Roll-Over or Reflation?
Published on: November 19, 2020 • Duration: 25 minutes
This week we look at the potential for reflation in early 2021, or for a rollover in economic activity. Government policy has already been incredibly loose, but so far it has provided little more than life support, even if US equities have rallied. It may even be that we get inflation, rather than reflation if consumers start to spend before supply chains are replenished.
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[00:00:05] In the aftermath of the US election, and in particular on the day of the Pfizer vaccine announcement, risk assets celebrated with an almighty rotation, jumping onto the reflation trade bandwagon. But is reflation really on the way or do we first have to negotiate a difficult few months ahead? That's The Big Conversation.
[00:00:27] On Monday, the 9th of November, the day of the vaccine announcement, we saw this euphoric rotation into the reflation trade and we saw some quite remarkable moves in risk assets. If you look at the Russell 1000 value, this is the beaten-up sector, the values versus the growth sector and value of things like cyclicals. We saw the largest one day outperformance of value over growth that we've ever seen. When we look at the S&P sectors, we can see a similar story where things like the energy sector and the financials massively outperformed. Again, these are beaten-up sectors. Financials were up about 8 percent and the energy sector up about 14 percent. And it wasn't just in US stocks. We saw US bond yields here's the 10 year, it touched one percent. Now, this is the highest level that we've seen since that mayhem of March earlier this year. And that reflation trade was also seen across the rest of the world with European banks, in fact, the eurozone banks having some massive outperformance as well. And that that momentum has actually continued in many of the sessions afterwards. But I think it's worth making a distinction between reflation and inflation. Reflation is really where you get economic growth, which might come with inflation, but the real driver there is that we are getting an economy that's starting to motor again. Versus inflation, which can happen on its own, and if we get inflation without economic growth, you get stagflation. And so it could be that we get reflation, but maybe we're looking towards inflation coming into next year. And what really matters is, is what's going to happen with a vaccine and perhaps more importantly, in the short run, what's going to happen with the fiscal support? Well, firstly, with the vaccine, clearly we've had some very positive headlines, but the logistics around this are still quite significant, i.e., we're not going to see the vaccine in a meaningful way for at least six months and maybe longer than that. And so therefore, the heavy lifting has to be done by policy. And we've got fiscal policy and we've got monetary policy. And to briefly recap, fiscal policy is government expenditures. So this is governments doing support of small businesses, furlough schemes, so wage support or income support. The monetary levers are the central banks, and historically, they've been cutting interest rates and then raising them when things get better doing quantitative easing, which has been the popular method since 2008, that's QE, and more recently, there's been a lot of talk about yield curve control. Now, what really matters is how much fiscal have we seen? Is the fiscal that we're seeing significant? Are we seeing a loose fiscal policy? And I think the answer to that is very clearly yes. When we look at this chart of the US budget balance, and the budget balance here is effectively the U.S. government income versus outgoings. It's the sort of net position of the US government. It has collapsed to minus 15 percent of GDP. And I think this is the lowest level of any major economy, certainly any major developed economy at the moment. If you also look at measures of debt to GDP, we can see again that debt to GDP ratios have exploded higher in 2020. Now partly that is because we've seen GDP collapse in the second quarter of this year. But nonetheless, it shows that there is a significant fiscal impulse. But is that fiscal impulse enough? Is that impulse support, is it recovery or is it growth? And I think it's still life support at the moment. And the reason why I think it's still life support is because we're probably going to go into a double dip recession in many parts of certainly the developed markets of Europe and the US, and we can see that GDP had that massive collapse in Q2. It's rebounded, but now real live data is suggesting that economies are slowing down once more, so we might get a decline in GDP in Q4, maybe into Q1 of twenty twenty one. And we can see this in a number of the sectors. So, for instance, if you look at airline traffic, airline domestic traffic in the US is starting to recover, but it is absolutely nowhere near the levels of pre-February. And the same is repeated through the restaurant industry and many other of the leisure and recreational industries that we have. And even if we do get a reopening of economies, there will be a reluctance to return to the previous levels of activity. So therefore, there is this drag on the economy. We're not going to get a full opening up, a full recovery. In fact, in many ways we're probably still at life-support levels. However, there are risks that we might end up getting some inflationary bottlenecks rather than reflation. And what we can look at here is the level of M2 and M2 is the sort of a broad based money level. And it includes things like checking and savings accounts. And M2 and this is the rate of change of M2 on a year on year basis, has exploded higher. Now what's interesting here is that it's exploded higher in 2020. Yet despite central banks doing so much monetary over the years before, the fiscal impulse, at least the M2 impulse, the M2 growth year on year was nowhere near as significant over the preceding 10 years as it has been this year. Now one of the problems that we've had in terms of inflation has been the mechanism for getting effectively liquidity into the overall system. When we look at what central banks have been doing is they've been crediting the reserves of the commercial banks. For money to grow, you need the commercial banks to lend that out to the real economy. And for that, you need those commercial banks to want to lend, but you also need the public and consumers, that is, and corporates to want to borrow. And on both sides, there's been a reluctance. The banks in particular have been reluctant because they've been worried about, effectively out there, what you have is those who are able to borrow are the ones who don't need to. And those who need to borrow are the ones who can't because they've got the worst credit ratings. So you've not had a simple mechanism for getting the reserves on commercial banks into the real economy. But what the US has done during the pandemic is that they guaranteed some of those bank loans. So they've given some protection to banks, which is going to encourage them to lend out. And what's more, we've seen a massive increase in US savings. In fact, we've seen a massive increase in savings in Europe as well. But you can see here that the savings ratio in the US reached over 30 per cent, close to 35 percent. And even today at 14 percent, it's well above the 20 or 30 year average. And when you look at that in actual personal savings, we've seen an increase of over one trillion dollars over this year. So that's currently been saved by consumers. And I guess what people are worried about in terms of the inflation that could come is whether that could suddenly become or that could suddenly be moved into the real economy. One of the questions is whether it will firstly be hoarded. Are consumers still worried about the future? And this goes back to are we coming out of Lockdown's and into a true reflationary impulse or are people still worried about the short term future? Over the summer, you saw quite a lot of expenditures because there was a novelty in being in lockdown and people spent on home improvements, et cetera. Today, people are a little bit more worried that this is an ongoing problem, even with the vaccine on the horizon. Yes, risk assets want to price six months into the future, but perhaps we actually have to price six months worth of a Covid winter before we can price in the potential reflation of a vaccine. Now, what that therefore creates is the potential of no growth. But what if we do see a little bit of consumption picking up? The reason why this matters is that over this period, we've seen inventories decline. We've seen bottlenecks created. Those bottlenecks have been created because if you think of those supply chains, they've been broken. And therefore we've got an environment where productivity is perhaps lower than it should be. But pent up consumption or potential consumption from those savings could be a lot higher. Now, at the moment, what we've seen is that the velocity of money has been collapsing. So even as things like balance sheets have expanded and even as personal savings have increased, the velocity of M2 has declined. So far, those savings have not found their way into the economy. But if they do and add to that the mechanism where the central banks are now or the governments are now guaranteeing the commercial banks, at least some of the loans the commercial banks are making, there is the potential for an inflationary impulse. But that's not reflation. Reflation is true growth. Inflation can be debilitating to growth. And we can see that in the 1970s is that during almost every period of high inflation, we saw inflation declining dramatically through recessions. And if anything, we're probably still in a double dip recession type scenario in much of Europe and the US. But why does this matter, what does it matter for the market? Well, the key here is that if you get inflation, you might get and you should get higher yields. If you get high yields but without actual economic growth, you could destabilize risk assets. Now, we've seen higher yields before, but when they've come with higher growth, as we saw with the taper tantrum in 2013, those higher yields came at a time which didn't really impact the equity market because the equity market was moving from low growth through to high growth at that time, at that moment in time. What we have today is still a period of low growth. Yes, we might have higher growth in the future, but at the moment we still have low growth, low GDP growth. So therefore, if you get high yields, you could destabilize the market. And even in times of normal growth or higher growth, if yields get too high, you can puncture risk assets. And we saw this in twenty eighteen, when the 10 year yield in the US got to 3.25 percent at the end of twenty eighteen, that rang the bell on the equity market, the equity market rolled over, and then there's the misstep from the Fed, the central bank of the US, that saw eventually the S&P declined by 20 percent into I think it was the 24th of December before it bounced out. And that's one of the big risk here, is that if you allow yields to go too far, too fast, then you could prick these asset bubbles and cause them to roll over. And another problem that we have is that we have QE now, QE, you'd think that QE, when central banks are buying bonds, would be something that pushes bond yields lower because they're buying bonds. Well if we look at the history of QE over the last 10 years, we can see there's been some very, very different reactions in different regions. In the US. They did QE by buying bonds, government bonds, corporate bonds and also mortgages. Yet it's the equity market that outperforms. Bond yields did fall over that period. But it's really the equity market that people focus on. In Japan, they buy everything, including equities. But equities don't outperform, though, as we'll see later, equities have done relatively well on a historical basis. In Europe they buy bonds, they buy loans. And sure enough, in Europe, bond yields have fallen. But even in Europe, when they're buying bonds, bond yields have generally gone higher. And when they stop buying bonds, that's when bond yields have generally fallen quite dramatically. So at the moment we've got QE and when we've had periods of QE, bond yields have gone either sideways or higher. The higher bond yields in an environment where you've got record levels of corporate debt in the US, you've got governments pushing to high levels of debt to GDP where the budget balances are blowing out. This is a sort of wartime footing in terms of fiscal expenditures. And you've even got corporate debt going up as well. There's a risk that bond yields are going to be incredibly destructive to risk assets and risk assets will be incredibly sensitive. Therefore, we might get yield curve control. And yield curve control is where central banks actively target a specific yield. So it might be, for instance, one point two five percent on the US, ten year. In Japan, it's 10 basis points. But there they're pushing yields up to 10 basis points, having seen them collapse at the beginning of twenty sixteen. But generally the expectation is that yield curve control would cap yields to prevent yields from getting too high. But then it comes that, sort of the final part of this, which is OK, it looks like we've got a potential inflationary impulse, but without growth, which is stagflationary rather than reflationary. But first, maybe we'll still see lower growth, lower yields. And if we look at that chart again of CPI, we can see that during periods of recessions, CPI has generally fallen through the recession and way beyond the recession. Then we think, well, what about that M2? M2 has exploded higher. What about other periods where M2 has been going up during recessionary periods? And if we look at 2000, the dotcom bubble, and if we look at 2008, yes, we saw on both those occasions M2 on a year on year basis going higher. On both those occasions we saw CPI to inflation going lower. Is today's increase in M2 sufficient to offset that so that we do get a true inflationary impulse? Well, if you look at CPI, Vs the year on year change in the velocity of money, and this is a 20 months, a five quarter differential between the two. And what we can see here is that we would expect CPI to fall about five quarters after such a massive decline on the year on year change in the velocity of money. So it still feels like the inflationary outlook is going to be firstly negative before it's positive, which means the positioning in bonds might be aggressively short, particularly the long end, this is the 30 year space where the net position is very, very short. Now, that's because when you look at sort of the inflation matrix, the front end is locked by the Fed being on hold for potentially two years. Ten year is fairly neutral at the moment, but in the 30 year space, there is a very, very short position, anticipation of reflation or inflation. Maybe that position is too aggressive now. So I think what we're going to see here is that inflation is probably a higher risk than reflation in the first or second quarter of next year. But actually, the more likely outcome is still for lower inflation and lower yields in the short term, because we still haven't got the mechanism to get those savings into the economy quickly enough because they're still going to be a lot of uncertainty over the next few months. But reflation is the buzzword at the moment, particularly after the vaccine. Equity markets like to look six months in advance. Maybe they've looked too far in advance. And first, you've got to get through this uncertain period. If you are long equities, it's probably worth looking at that long end of the bond market and potentially having some long positions on there in the anticipation that those yields could still fall because that would offset any weakness in equities if indeed this is still going to be a winter of discontent.
[00:15:11] In the last section, we looked at the potential for reflation, inflation and in fact a continued slowdown, but reflation is obviously one of the bits which people are really focusing on. So what would happen or what should we expect if we do get true reflation? And again, I'd like to emphasize reflation here. I'm thinking of economic growth, not just the inflationary impulse. And I think there's two other elements to this as well. One is that. When we've seen reflation before, it's really been driven by, you know, it's almost been like an organic growth, it's been sort of true growth, but often the impulses in the last 20 years come from places like China. Perhaps the big reflation trade was post the dotcom bubble between 2002 and 2008, where we saw China really coming into the global economy. To a lesser extent, we saw reflation in 2016 and 2017, again, when we saw the Chinese credit impulse pick up and we saw initially a rebound in commodities. This was after the commodity and industrial bust of 2014 and 2015. On all those occasions what we saw was a weaker US dollar. And so a weaker US dollar has some very significant implications for risk assets. So should we see this again? Well, if we get a fiscal based reflation, which is driven by government expenditures, particularly out of the US and maybe Europe, should we expect the dollar to fall again? And the assumption that people are seeming to take here is that, yes, we should, although the big problem here is if the US is doing it, but Europe is also doing it and Japan is also doing it, then is the US doing it in enough size to destabilize the dollar to the downside or in fact, is it the euro and the yen that might be the biggest movers? And I think at the moment we've got this fiscal impasse because we probably won't get any expenditure out of the US government because there's there's not a unified government unless something happens in Georgia in the new year, which seems relatively unlikely. Therefore, there's probably going to be a bit of to and fro before we get the next fiscal. And in Europe, the ECB or at least the European authorities, their fiscal will not be forthcoming because they've only just agreed a deal back in July of this year. So we're looking for the ECB to do more monetary in December, December the 10th. I think the Fed comes on the 16th. But let's say we did get a proper fiscal impulse from the US. The assumption still is that if it's the US and they go in the big enough size, then the dollar will fall. And the dollar has significant implications. And this is because of the dollar smile. If we get reflation, what we should see is dollar on the back foot. Now, that's not really dollar weakness. What it is, is actually other currencies that are stronger, other economies that are doing well. If you get co-ordinated, global growth, coordinated global reflation, emerging markets should do well, as we saw in the decade 2000 to 2010, particularly 02 to 08. And therefore the dollar is weak because those higher beta currencies are doing better. And this is a chart we've seen before. This is the dollar smile. And that dollar smile is where you've got strength in the dollar, when you've got strength in the US economy make the US strong again, as we saw at the end of 2016. When you've got global weakness, you often see the dollar strength, strength because of weakness elsewhere. So that's the rush to safety, the safe haven trade. But in the middle of 2016, you had the bottom of the dollar smile where the Chinese growth impulse was allowing global coordinated growth to kick in. And that actually lasted for two years with just that dollar impulse at the end of 2016 after the Trump election back then. But what's remarkable is that what is, I think a remarkable chart is when you look at the dollar, this is the DXY versus the ratio of the S&P versus the MSCI emerging markets. And on this chart, you can see when the DXY is falling, this is the dollar that's weak. You can see that the S&P underperforms MSCI emerging market. So therefore, the charts going down. In 2008, you started to see a bottom in the DXY and then in that disinflationary rebound we got out of 2008 and financial crash, you saw the dollar strengthening again and US equities led emerging market equities led by particularly the US tech sector. But that reflationary environment, if we expect reflation, we should expect the dollar to fall and therefore we should expect emerging market equities to outperform. Perhaps one of the great reflationary trades of the last 20, 30 years is Japan. And so that's another one to look at. And why is that a reflationary trade? Why is it the one that all the big hedge funds used to like? Well, in this chart here, between 1991 and 2012, you can see that the Nikkei 225, the Japanese equity market, versus the US ten year yield, they're in lock step for a 20 odd year period. In fact, this is rebased to 100. So they actually fell together about the same amount. Now roll on post 2012, you can see how Abeconomis actually did break the stranglehold of reflation or the reflationary impulse of yields. And actually Japanese equities started to break away and performed pretty well. So the Japanese equity market is an inflationary market because you can see here how when US 10 year yields rallied, going up, those are periods of growth reflation and the Nikkei being an export, Japan being an exporting nation did well, when the yields were rolling over, Japanese equities performed less well because, remember, demographically and internally, there was deflation and disinflation going on. Now Abeconomics broke back in 2012 when you saw the equity market break that stranglehold. But ultimately, it's still very much a reflationary style of market. And although we're still below the 1989 peak, it doesn't look like particularly led by the Nikkei 225, that Japanese equities are performing pretty well. If there is a deflationary impulse, they should do well, too. In Europe, it's less clear cut. Europe needs emerging markets to perform before Europe can perform. A lot of European exports are to emerging markets, and therefore, if I was looking at reflation, I would look at emerging markets well before Europe and if I was looking at Europe, I would look at the DAX first and foremost, because that's one of the big exporters, particularly of industrial goods to those emerging markets. Now, obviously in a true reflationary impulse and pick up where you're getting monetary debasement and you're getting economic growth, you look at precious metals, particularly those with an industrial element such as silver, platinum and palladium. Gold should do okay as well, but it should underperform things like silver in that environment. So precious metals with an industrial element should do well. So overall, if we're looking for a true reflationary impulse, you want to look at emerging market equities first. We want to look at Japan. But if yield curve control comes in, keeping those yields below so that, you know, there is no real move in yields and real real move in bonds, then my guess is still that those passive funds, which have dominated flows for much of the last five to 10 years, will still look at those US tech stocks. So this is not a story about US stocks necessarily going down or people moving out aggressively, it's simply about it outperformance in Japan and the emerging markets if we get a true reflationary impulse. But my guess is that's not going to happen until well into next year and maybe beyond.
[00:22:18] As discussed in the earlier segment, there was a huge shift towards a reflation narrative after last week's vaccine announcement from Pfizer. Was this just a short covering rally in which some of the highest beta sectors outperformed? Or was there also an increase in the actual data usage of the cyclical and value sectors that suggest it was more than just a one off rebound? David Craig, CEO of Refinitiv, highlights some of the key trends in data usage.
[00:22:41] While optimism roared back this week and the market has changed its position to really a risk on. Look at the spike in optimism in this chart from our Partners Market Psych, based on the US news and social sentiment. We saw a record volume of trades in our wealth management system at the open in New York, reflecting the amount of retail activity we are seeing back across our platforms and in the markets. Customers were using four times more data in the France CAC, the DAX, FTSE and Hang Seng and across our user base activity was up with some fascinating moves in hedge funds in particular. They increased their use of money market data on EIKON and Workspace by nearly three times. We rotated out of the short term cash and into risk assets after Pfizer's news on Monday. That's great news for sectors like longsuffering US banks. They were knocked down on the initial election result, the lack of a democratic clean sweep, nixing the chances of a quick reflationary stimulus. And we saw data demand from the main US bank ETF experience a big uptick as investors sold down the sector. What a difference a few days makes. Pfizer's vaccine news changed the market picture completely, giving hope that the economy could bounce back fast even with the control of the White House and the Senate potentially split. Demand for data on the main US banking index rose even higher on Monday than on the previous Wednesday. The index itself jumped 13 percent in value. But Monday's surge wasn't just a sector rotation. It's regional as well. We saw a far steeper climb in the use of financial data in the regions outside the US on Monday. Places like Japan, Southern Europe, Latin America, which all depend on an open global trading system with a Biden presidency making that more likely and a vaccine hopefully reflating economies everywhere, we'll keep watching the data to see how broadly the ripples of this week's double dose of news, fan out.
[00:24:37] The price action in banks last week was preceded by a significant increase in data usage. Investors had clearly started to warm to the theme when bond yields started to rise and the yield curve steepened even prior to the vaccine headlines. U.S. banks in particular look like a great reflation play. But it was the final point, which was perhaps most interesting. There was a clear jump in data usage for regions that would benefit the most from true reflation. As we saw earlier, Japan is a classic reflation play which has largely gone unnoticed in recent years, whilst emerging markets, especially in Asia, would perform well if reflation also comes with a weaker US dollar.
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