The Big Conversation
Episode 55: Could the reflation consensus be wrong?
This week we review the overwhelming consensus for reflation trades in 2021, based on the combination of fiscal and monetary policy, plus the arrival of the vaccine. Already a consensus in late 2020, the theme has built even more momentum into the New Year, with almost all investors favouring short dollar, long commodities, and long emerging market equities. A consensus on this level can easily lead to disappointment.
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[00:00:05] As we come in to 2021, this chart of US M2 money supply growth is at the very heart of an overwhelming consensus which expects that the combination of a vaccine plus massive fiscal and monetary support will result in a huge rebound in growth and inflation, that will continue to drive demand for reflation trades. But where could this consensus be wrong? Well, that's The Big Conversation.
[00:00:32] In twenty five years of being in financial markets, I've never quite seen an overwhelming consensus for a New Year like the one we're seeing today. Pretty much every broker, investment bank, pretty much every asset manager and hedge fund manager is looking at some form of reflation trade for 2021. So what is that reflation trade and what are people playing? Well, we can see from some of the conversations on the Refinitiv platforms with clients that there is an overwhelming consensus for a number of specific trades. Now that one of the core of all of this is being short, the U.S. dollar, almost everybody believes that the dollar will be weaker throughout 2021. But what are the other trades that really play into this same narrative? Well, obviously, we expect yields to move higher or people expect yields to move higher. That's very core to this narrative as well. And here we can see the US 10 year yield and there's probably a range that's been building off somewhere between one point two, five and two percent for that 10 year yield. Now, when you look at this chart, that would suggest that we're going to see a level which is above where we were pre-Covid. So that's a pretty impressive move. Remember, when yields move higher, as we've seen before, in true periods of growth, it actually becomes quite tricky for markets to deal with those higher yields. But nonetheless, that is the expectation is that yields will move that through those levels. In the credit space, people are expecting high yield to outperform investment grade. In the equity space, people are expecting emerging market equities to outperform US and developed market equities. And that's already been working quite nicely, and even at the beginning of this year, we've seen a nice move down in the ratio of the S&P versus MSCI emerging markets. And following that theme in equities, we've also seen that small caps are being favored over large caps, low quality, over high quality. We're obviously seeing people looking at cyclicals and and value over growth. So people are thinking about energy stocks and financial stocks. Some of these stocks which have been beaten down and looking away from the growth stocks that have driven the market particularly through last year, but actually for most of the last 10 years. And obviously, commodities is very much at the heart of this narrative, at the heart of this reflation thesis. As you can see here, this is the Refinitiv Commodity Index, equal weighted and on this I've also mapped the dollar index. We talked about the dollar earlier. This is the dollar index inverted, so when the dollar is weaker, on this chart, the lines going up, that should see commodities going higher. But it does look like the dollar has been leading commodities, and we will come on to that as a key element later on. But when we're talking about reflation, and this is something that we touched upon in the last Big Conversation of 2020, is what type of reflation are we talking about? Are we talking about reflation or inflation or actually could we see disinflation return? And the key here and I talked about the dollar, is that are we seeing dollar driven reflation or are we seeing the sort of reflation that you normally see with synchronized global growth? And for that, the best chart to demonstrate those differences or at least demonstrate the importance of the synchronized global growth is the chart of the ratio of the S&P versus MSCI emerging markets against the dollar index. Now, the key area to look at over the last 20 years is the period from around about 2002 to 2008. This is the period where China came fully into the global market. It was a huge consumer of commodities and that drove demand for commodities and emerging markets. So what you saw in this environment was synchronized global growth based on China being led by commodities in which emerging market currencies, the high beta currencies, performed well, meaning that the dollar underperformed, but it was synchronized growth that was leading the charge. We saw a little bit of this in 2016, 17 and 18 as well. Today, however, what we're seeing is very much a dollar led drive. i.e a weaker dollar is driving commodity prices higher and emerging markets higher. But is that as sustainable as one where true global synchronized growth is in the driving seat? And that's something which I think is going to really inform whether this consensus trade has become a little bit maybe ahead of itself in terms of where we are today. Because remember, when we look at this next chart, this is the US. CPI it's a chart that we showed before. This chart shows that when you have recessions, inflation is normally on a downward trajectory. It might be disinflationary rather than deflationary, but into an out of or at least in the middle of an out of every major recession we have seen CPI in the US falling since the 1970s. And if anything, globally, we're probably going to see a double dip type of recession. Here in the UK, we've just got into a lockdown, which is not quite as ferocious as the one we saw in March, but it's not far off. Now obviously, we're not as nervous this time around and people will probably be a little bit more lackadaisical with how they deal with this lockdown, but nonetheless, it's a lockdown that's more commensurate with what we saw in March. The difference being that this time in Europe, we're seeing a synchronized lockdown. So the whole of Europe is going into a lockdown in some shape or form at the same time. And that's going to have a negative impact on GDP. Yet here we are at the beginning of 2021 talking about reflation and the consensus on reflation and inflation and that story has actually been building momentum over the last few weeks. So what is it that been driving this reflationary narrative or inflationary narrative? And again, we're going to have to make that distinction. Now, one of the things that we showed the very beginning was that chart of M2, and I've got another chart here, which is the absolute level of M2. Now M2 has exploded high. We all know that. And this is one of the main driving forces of people thinking, well, this has inflationary potential. And it is correct to say that that has inflationary potential. Perhaps the potential is not quite as dramatic as people think. Mike Greene of Logica Capital, argues that much of this increase in M2 and this is things like checking accounts, among other things, is due to the drawdown by corporates during 2020 of credit lines for the banks. And this is something that Dave Puchowski of Refinitiv talked about when he was looking through the Corona Correction and how people were drawing down their emergency funds from banks. So corporates have been drawing down this credit, putting it into their checking accounts. That's part of the build up in M2. But in some ways, the way we can think about that is that the surge in M2 reflects the current economic dislocation as much as it represents future inflation. Now, the future inflation potential, but actually perhaps it's more reflective of the current dislocation. The second part we've also talked about is how in this furloughed environment, we've seen savings in US and in Europe also explode higher, something like one point twenty five to one point five trillion as people have been stuck at home, they've been receiving their wage support, their income support, and they've been putting it on deposit in checking accounts. So, again, that is helped this M2 number build up and has created this expectation that M2 having built so rapidly, and this is far more rapid than we saw in any of the other previous recessions, this build up in M2 is now going to have inflationary implications going forward. But what are those corporates are seeing that because of furlough and wage support, there is now no need to use those drawn down lines and they repay them. They give them back to the banks. That would be very transitory spike in M2, which could roll off once markets properly start to open up sometime through 2021. And one of the other things that Mike talked about was the bringing forward of demand. So what we saw in 2020 was as everybody went into lockdown, we substituted demand for services such as going to restaurants and taking holidays for demand for finished goods and commodities. We stopped going to restaurants. We cooked at home. We stopped going on holiday, and we built a garden sheds. We built extensions on our houses. And this saw an incredible increase in demand for a lot of finished goods and also for a lot of commodities. So this was a substitution effect. Now, if that demand has been brought forward now, obviously we are still potentially going into another lockdown. But the chances are that instead of now building more garden huts and building another extension, we might save that money. But that demand was brought forward. And also, when you bring demand for it like that, we push prices up. There will eventually be a response from supply so that demand will be met by a larger amount of supply and then that demand might fall off because logically, as we come out of lockdown, we should go back to restaurants and we will hopefully go on holidays again and we'll spend less on commodities and finished goods. So perhaps that demand has been brought forward and also put some pressure on the dollar because a lot of these finished goods would have been coming from overseas places like Korea, Taiwan. And so a lot of demand for electronic goods, commodities might be domestically sourced for the US, but also some of these commodities would have come in from overseas. So that was also a driving factor for the dollar, is that this shift from services to finished goods and commodities probably increased the demand for overseas goods and that would have put some pressure on the dollar as well. But that's a transitory effect. We've also seen as well. And this is a key element, which is why inflation is perhaps a bigger risk for twenty twenty one than true reflation, which is true growth. Where inflation is brought along for the ride is that we've seen those lumber prices move incredibly high. This was a bottleneck. It was a bit like the process that we saw last year process be spiked aggressively in the second quarter of 2020, but that was a supply chain impact. The same happened in lumber. In fact, lumber fell when people came out of lock down in Q3 of 2013 is now spiked again. But we're seeing these spikes in commodities across many, many areas, including soft commodities. We've seen soybeans, we've seen coal. We've seen they've all been moving aggressively again as well. A lot of these are supply chain issues. Along with that dollar impact, weak dollar has been driving commodity prices higher, then builds momentum with hedge funds, particularly fast money positions chasing after these momentum trades. But is that sustainable demand or is this simply bottlenecks with a dollar impact? So maybe what we've actually been seeing and one of the reasons why maybe we should be a little bit cautious about jumping to aggressively into this reflationary consensus is that maybe that energy surge that is driving a lot of the expectations, particularly on the fiscal side, is going to be very transitory as the corporates pay that back to the banks. We've also seen that demand has probably been brought forward. We've seen this incredible move in the dollar because the expectation is the Fed is going to be the most aggressive, which is helping drive those reflation trade. We've also seen these bottlenecks and supply chains creating surges in commodity prices. Now, when you look at all of that, it looks like inflation and it looks like reflation that maybe these are just reactions to things like the weaker dollar. And something else that we should also bring into this is that when we look at inflation expectations, they've moved, but they haven't moved maybe as dramatically as we would have expected. If there is a true reflationary narrative out there where we look at things like term premium on the US 10 year and some premium is a sort of a premium for inflation that you build into the term structure of the bond market. Longer dated bonds should have a higher term premium, higher inflation expectations. So premium went negative a couple of years ago for the US 10 year. It has rallied and is now above where it was predictable, but it is still in negative territory. That's not saying people have massive inflation expectations for the future. One of the other things that we've seen from the market is that things like the tips, this is the inflation protected securities, the five year the tenure in the US have recently touched two percent. So people are saying now the market expectation and expectations are so important in inflation have reached two percent highest level in nearly three years. But how they got there, what one of the biggest drivers of the tips market has been the Federal Reserve buying those securities to drive inflation expectations high. Now, why would they be driving inflation expectations high if the market already thought that inflation was going higher? It's a bit of a deceit on the part of the Fed. They are needing to drive those because they want to create the expectation of higher inflation in the future. But when we look at nominal yields, they have flatlined. Now people will say, well, that's because of QE. But actually, historically, as we've talked about before, when you do QE, normally yields do go higher, yields have been flatlining or it's really been happening here, as has been Federal Reserve pushing its market higher. Really yields have fallen. That's one of the reasons why gold has been doing well. Remember the inverse relationship between gold and those real yields. So a lot of this is driven by a lot of these reflation narratives are driven by a weak dollar and the effects of the central bank, the Federal Reserve, in things like the tips market. And then finally, another chart, which again suggests that this reflation narrative is not actually playing out as clearly as maybe people think is that German bond yields. This is the 10 year yield. Now, Germany in Europe is a reflationary play. If it was true synchronized global reflation, you'd expect Europe to do very, very well because they export lots of stuff to emerging markets. But here, bond yields have actually been grinding lower pretty much since the middle of last year. There's nothing impressive in this in terms of the reflationary trade now, partly because the euro is stronger. But if the euro is stronger in a recessionary environment, there would still be lots of exporting going on. So it wouldn't matter and you'd still see yields going higher. But what we've got in Europe, the yields grinding lower. So when we look at things like tips, when we look at term premium, when we look at bond yields, that reflation narrative, which is a narrative among active managers in particular, is only partially playing out. So in summary, this reflation trade, it's based on some very real moves in asset prices. And given the consensus, it probably should continue into twenty, twenty one. But it doesn't look like it's a reflation trade based on synchronized growth. It looks like a reflation trade based on a weaker dollar and that we really requires the Fed to be the aggressor. At the moment, the Fed and the ECB balance sheets have actually expanded by about the same amount over the last 12 months. We've seen M2 explode higher, but that explosion, an end to it, doesn't necessarily mean it's going to be moving into the economy with a velocity that drives up inflation. In fact, it may be that it gets repaid if the worst case scenarios with demand don't materialize and those cops feel that they can pay it back. Demand has been brought forward. And as we move out of lock down, eventually in 2020, we'll move back toward services that demand to commodities could way that demand for overseas currencies could weigh and the dollar could find itself on a stronger footing once more. So I'm not saying that the reflation narrative is incorrect, but what I am saying is that it is the biggest consensus going into the new year I've ever seen, and maybe the stories behind it are not actually true synchronized reflation. And therefore there is a lot of risk in that trade if you're going all in at this point in time.
[00:14:43] In the last section, we looked at this incredible consensus in the narrative of reflation in this section, I wanted to see whether that consensus was much more within the narrative, whether it was also among positioning as well, because if it's not in positioning, then maybe the narrative has legs or maybe that the real market doesn't believe the narrative that's mainly been formulated among active managers, hedge funds, etc.. Now, what we look at some of the surveys, things like the Bank of America survey, we can see that the classic reflation trades are the ones that people think will outperform in 2021. One of the really stands out is emerging market outperformance, and this is actually increased in popularity since November. US equities are also popular gold, oil. So these are all very much those classic reflation trades. But is that borne out by positioning? Is positioning extreme? I'm going to look a few of these positions now. Well, firstly, let's look at the dollar and look at the euro. First, euro positioning is extreme, but it's off the highs. And you can see here that over the last 20 or so, 30 years, this position that we've seen, the net long position in the euro shorting the dollar has only recently come off an all time high. And when these positions have generally pulled back in the past, we've normally seen that the euro has also come under pressure as well. So euro positioning is extreme, dollar positioning is extreme copper futures. This is the next speculative positioning in general. Looking at the next speculative positioning, which is sort of fast money types of people and speculative positioning in copper is at an absolute extreme, marginally off the top again, but pretty much as you can see very much at those high. So people really embraced the copper, the growth narrative, the reflation narrative through the copper futures market. Now, one of the other areas which been a very much consensus through 2020 was precious metals, particularly gold and silver and gold. The positioning there, the long positions, the speculative positions, they are relatively extreme. But I wouldn't say that this is an incredible extreme. When you look at this sort of five year chart, people are long gold, but they're not exceptionally so. But when we look at silver, silver, we can see is actually quite neutral. And in some ways, if you truly believe in reflation, then the silver positioning should be much more extreme than gold, because so not only being a precious metal play is also an industrial metal play. So if you get through reflation, through growth, through industrial outperformance, then silver should perform very well. We would expect it silver to be much more aggressively positioned than it currently is. And then when we look at the bond markets and a lot of people expect that bond markets are where we're going to see this expression of growth play out, yields are going to go higher one point to five to two percent range for the US ten year. But actually, when we look at the two, the five and the 10 year positioning, it's all fairly neutral. So in the bond market, the extremes are not there. At least they're not in that core part of the bond market. A lot of people might say, well, that's because central banks through QE have taken all the volatility out of the market, there is nothing much to play for in this sort of front and middle part of the curve. So whilst those, the sort of core part of the bond market, from that 2 year to the 10 year space looks relatively neutral, what about the 30 year space? Because the 30 year space is where if there is going to be inflation or inflation expectations are truly going to play out, then you'd expect that to be a net short position in that longer part of the curve where you expect yields to go higher. And as we can see in this chart, that net position of long versus short is quite extreme on the short side. It's bounced off the position we saw at the end of last year, but nonetheless, on a historical basis, this is quite an extreme position for the 30 year bond future on the short side. So when we take all of that together, it would suggest that perhaps the narrative is more extreme than positioning. Where we are seeing positions that extreme they are more to do with the dollar and the commodity complex. So this is the dollar relationship, dollar reflation rather than true synchronized growth reflation. Core bond market doesn't suggest there's really that much of a strong view on growth, on reflation until you get at the long end, which is the inflation sensitive part of the market. But overall, I think that the market is not necessarily playing this reflation narrative as much as active managers are talking about it, which again, makes me feel that we're a little bit too early. We've got more lockdown's coming, we've got a period potentially of a double dip recession, and if we do get the true story of reflation and even if we get the true story of inflation, that's a story for the second half of 2021, not for the first half and certainly not for the second quarter.
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