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The Big Conversation

Episode 56: Hedging for a reversal of reflation

This week we review the dollar-based reflation trade versus the global growth narrative. It’s not that reflation trades are wrong, but that the drivers may be more transient than previous bouts of reflation over the last 20 years.

  • [00:00:05] Last week, we looked at the popularity of the reflation trade, which has built a big consensus amongst the active investment community. But this is a very different type of reflation trade to the one we saw in the early 2000s and to a lesser extent, from 2016 to 2017. So what sort of simple hedges should investors think about to protect any gains that they're making from this trade? That's The Big Conversation.

    [00:00:34] One of the key decisions that investors have to make about this move in asset prices is whether this is a reaction to a weaker dollar or whether we're seeing true global reflation, synchronized growth, driving these asset prices. Now the reflation narrative itself is very, very compelling, but it's not a particularly new one. In fact, we had Julian Brigden of MI2 Partners on this very show in August putting out there his short dollar thesis and reflation trade ideas. But this narrative is really gained some steam since the election and particularly since the vaccine headlines on the 9th of November. So I think we need to look at what it is that maybe suggests this is global growth or otherwise, or whether this is just a dollar move. I think first we can look at the ratio of gold vs. silver. Now gold and silver, both precious metals, both benefit from a lot more fiat currency, so money printing, etc. But if this is true, global reflation, so industrial, economic reflation, then we should expect certainly some significant outperformance from silver. Now what we can see in this chart is that silver has outperformed through the second half of last year. But since November, since this narrative has really picked up steam, silver has only marginally outperformed. It should really be a lot higher than gold relative to where it was at the end of Q3. So this ratio of silver versus gold, should really be seeing silver doing a lot better than it is if there was true, global growth out there driving industrial demand. In a similar vein, we can look at European equities versus the S&P. European equities themselves are not so sensitive to currency, but what they are sensitive to is demand in emerging markets. So if emerging market demand is very, very strong, that's usually good for European equities. Again, what we can see here is that since November, we have not seen much outperformance if any, of European equities versus the S&P all the outperformance over the last two and a bit months came at the very beginning of November after the election and after the vaccine headlines. But since then, when the narrative for reflation has gathered steam, European equities have not outperformed the US. If there was true growth, we would expect to see those European equities outperform. Now this is a topping formation that we can see here. So there is potential, it may be that this is a topping formation, lagging the one we saw in emerging markets by a few weeks, but nonetheless it has been very unimpressive the performance of Europe versus the US. And despite the stronger euro, people could say, well, the stronger euro is a negative, but in true reflation that industrial demand will far outstrip any move in the currency and we've not seen that so far. So there are these various signs that this is not true global reflation. We looked at some last week as well. But let's look at the dollar. And what's interesting about the dollar is that the dollar moved down, this leg down that we've seen, has been bookended by the election. This leg started lower at the beginning of November with the election victory for Biden and then the vaccine. And we've just seen the best four day period of dollar outperformance since the Democrats got the blue sweep by winning Georgia. Profit taking on the dollar trade. This feels like the dollar is the key determinant of all these risk assets are not real true global growth. And this is something that we can see in this next chart where we have copper versus the Korean market, the Kospi 200 versus the dollar index, which on this chart has been inverted. They're pretty much the same chart over the last three years. Emerging markets, particularly Asia, tend to be more sensitive than things like Europe, and here we can see how those dollar sensitive assets are reacting to the dollar move. It's the dollar that's driving those risk assets higher. And it's not global growth that's driving emerging market equities higher, which means the dollar will be on the back foot. It's the other way around. So that brings us onto this narrative, which is OK, fiscal, monetary, vaccine all together, creating this reflation narrative. And one of the big arguments within this is that the Federal Reserve, in particular, the central bank of the US, is going to be the most aggressive. And in some ways, there's a little bit of an inconsistency here, because what we can see is that the US Federal Reserve was aggressive at the beginning. So back in March, they expanded their balance sheet very, very rapidly. But since then, the ECB has caught up and has overtaken the Fed in absolute terms. So the Federal Reserve is not the most aggressive central bank at the moment. If we then look at central bank balance sheets compared to GDP, we can actually see that the US is lagging behind the ECB, and both the ECB and the Federal Reserve are significantly lagging behind the Bank of Japan. So the Federal Reserve is neither the absolute most aggressive central bank, nor is it in relative terms anywhere near the most aggressive central bank. And what's part of this narrative is that, well, OK, the Federal Reserve might be the most aggressive, and I don't doubt that they have more opportunity to react, we saw that at the beginning of this whole pandemic. They were the first and the hardest to react. But then we look at the actual move in the currency and the idea that the central bank of the US is going to do more expansion, monetary expansion, balance sheet expansion, and that's going to drive the dollar lower. What we can see here is actually when the Federal Reserve was doing the least and the ECB was being more aggressive, that's when the euro started to go higher, going from 109 to 122. So actually when the ECB was expanding its balance sheet at the fastest rate is when the euro rallied, not when the Federal Reserve was expanding its balance sheet, pushing the dollar lower. So in some ways, that narrative that we've been listening to, or has been some of the common narrative, is inconsistent with what's actually been happening. Now these are coincidental moves. I'm not saying that one necessarily influences the other, but the euro has been going up when the ECB has been the most aggressive in expanding its balance sheet. And so what does this really mean for the US if this is not global reflation, but asset prices reacting to a weaker dollar, pushing reflation prices higher, then what we might end up seeing is that reflation is being priced in more aggressively into a lot of US assets, and therefore we might start to see a growth premium into the US. Now, this has a couple of implications. The first one is that policymakers tend to react to risk assets. If policymakers are seeing the US looking much healthier, they will be less inclined to do more. And as I said before, the Fed reacted very, very aggressively back on March 23 when there was a crisis. But as the crisis appeared to dissipate, as risk assets moved higher, the Federal Reserve has stepped back. The US policymakers have stepped back. They've not been as aggressive. The point is that it needs the market to signal that they need to be more aggressive before they will be. In the meantime, what we're seeing is that we're seeing that growth premium coming into the US. Bond yields in the US are going higher. So the 10 year yield has been breaking out, it's now above one percent for the first time since March. We're seeing the yield curve steepen. This is making US assets such as financials and cyclicals look more attractive. At the same time, we can see that in Germany, the Bund is actually going nowhere. It's been grinding slightly lower at the same time that the US ten year yield has been grinding higher and now breaking out. This means that the differential between the US and Europe is widening out once more. Now, it's nowhere near where we were at the beginning of 2020, when the US 10 year yield was at one point eight percent and Bunds were at 25 basis points. But nonetheless, the spread is widening out. This will start to make US bonds and yields on US bonds look attractive to an international investor. The point here is that if you get reflation assets in the US performing well whilst the rest of the world, which needs global synchronized reflation, is only reacting to the dollar, eventually capital will get sucked back into the US and that will allow support for the dollar and may even drive it higher, just when people are going all in on that global reflation trade. So if you think that this is a dollar move and not a global synchronized growth reflation move, then there is a blindingly obvious hedge to put on. And that's being long dollars, but long dollars. I think through optionality. What we're looking at here is a chart of volatility, which is three month volatility of the euro versus the US dollar. And apart from three spikes that we can see here, the actual volatility on those options is around about the lows of the range over the last 20 years. So volatility in the FX market has been suppressed by central banks. So that makes options on the currency look quite attractive. At the same time, a chart we've shown before is that the euro positioning is extreme. So longs on the euro are just off their all-time highs. If we do see a pullback in this positioning, as we can see on this chart, the euro has often corrected back down between 5 and 10 percent. So there's a risk that this dollar move could reverse and positioning could unwind, because a lot of these moves are speculative positions from hedge funds chasing the reflation narrative of the weaker dollar, not stronger global growth. We can also look at the difference between puts and calls on the euro or the dollar to see whether this is a reasonable trade to think about in terms of hedging that reflation trade. When we look at the risk reversal, this is the euro risk reversal, again, three months. We can see that the difference between a 25 delta put and a 25 delta call on the euro is about zero. So one is equal to the other. Now, there have been periods actually where pricing the downside in the euro has been much more, but it's round about neutral on a three or four year view. But nonetheless, it was suggested if you wanted to buy the downside on the euro, the upside on the dollar, it's a reasonably good time based on the look back over the last four or five years. But of course, if we're hedging a portfolio of reflation assets with currencies, we need to adjust it for notional. The reason being that commodities and equities, the volatility is significantly higher than most currencies. If you look at something like copper and emerging markets, we're talking 20, 30, 40 volatility versus the CVIX, which is the volatility index for a broad range of currencies. And as we can see in this chart, the volatility of the FX market is significantly lower than the volatility of the equity market. This is the CVIX versus the VIX, which is the S&P 500. What it means is you need slightly more notional on your dollar hedge than you have on your underlying reflation or commodity and equities position. It's a bit like thinking about when you had or people used to have the bond versus equity portfolios, where the bonds would decline slightly when equities were rallying, but when you had a collapse in equities, bonds would rally and offset some of those losses, but not all of those losses in the equity. Similarly, you want to position in the dollar, which will mitigate some of the losses, but it's unlikely to actually offset them completely. This is a hedge to reduce the losses if the reflation trade turns out to be short lived and based purely on the direction of the dollar. Another hedge we can think about, and it's not really a hedge, the short term moves, but it's an opportunity that we might get from the reflation trade. We saw this on Friday when those yields on the US 10 year started to move higher, nominal yields, didn't bring the real yields higher, but that was the potential. But when real yields and nominal yields move higher, we often see pullbacks in gold. Gold came off three or four percent on that Friday move. These are opportunities to build gold positions because going forward, I do expect there'll be more fiscal, so there will be more monetary debasement that will be good for gold. And if we again go into a world where growth is seen to be very, very weak and governments and central banks have to do more, then that's a great environment for gold, and probably real yields will head lower once more and gold will head higher. So building gold positions into that weakness. So it's all about keeping it simple. This is a move in reflation assets on the back of a weaker dollar, not a move in reflation assets, because we've got global reflation. Therefore, the hedge should be the first port of call on the dollar. That's the thing that's driving it. If the dollar reverses, that's going to cause all these other assets to roll over. FX volatility looks relatively cheap versus these other asset volatilities. And so that's the easiest and the cheapest way to do it. You need to buy a little bit more notional, but ultimately, if this is a dollar based trade, currencies rarely move in a straight line. And we've come into the new year with a very aggressive narrative from the active investment community. It's on one side of the boat and they can move very, very quickly back to the other side if we don't see global growth pick up properly to drive this next leg higher.

    [00:12:16] Early in the second quarter of 2020 Refinitiv's Cornelia Andersson joined us to talk about the collapse in global M&A volumes due to the pandemic. Now whilst M&A activity rarely translates into immediately actionable opportunities, I still wanted to ask Cornelia about the evolving trends that may impact markets in 2021.

    [00:12:33] What a year 2020 was for M&A. It was really a tale of two halves. So in the first half we saw activity virtually grind to a halt, and there was very little going on. Then as we approached the summer in the second half of the year, we had an absolutely record second half of the year for M&A activity. So talk about a rebound. We saw volumes return in the second half of the year that took us almost up to where we were in the year before. What we've seen is really a situation where as the year progressed, the large corporates in particular spent the first half of the year dealing with the shock of the initial crisis. So they spent a lot of time shoring up their balance sheets, making sure that they had access to appropriate funding. And then as we moved into the summer, large corporates largely got comfortable with the new normal and they started to revise their M&A strategy and they started to be open to doing deals again. So we have absolutely seen the return of the megadeals. So once again, the second half of 2020 was a record time period for megadeals, and by megadeals we mean transactions over 5 billion dollars. We saw almost a trillion dollars worth of megadeals. And these are really the large corporates that are, they have deep pockets, they have access to very cheap debt financing, as we know, in this low interest environment, that is a big driver of M&A activity, and with a renewed sense of confidence.

    [00:14:06] The obvious explanation for this activity is that we are seeing consolidation as well as sector specific concentration in areas such as tech, where cash balances are high and there is easy access to cheap capital.

    [00:14:17] We're seeing a trend of consolidation in several different industries. The asset management industry in the UK, in Europe and the UK is a very good example of that, whereby we're really seeing the dominant players focusing on their smaller rivals to be able to achieve that scale, to manage the cost basis, to tap into new customers in new markets very, very effectively. Overall technology had a massive year in terms of M&A. So we saw some very, very large transactions there. And what I personally find is very interesting is the renewed focus on workflow and collaboration tools. So as a result of the economic crisis, we're all working virtually now. So there's a renewed interest in these types of tools. So a great example is Salesforce acquiring Slack for 28 billion dollars, a megadeal, a technology deal, a large corporate deal. That deal really hits on the key trends that we've seen in 2020. One of the very interesting things is that we're seen an uptick in cross-border deals. Right, so you might almost assume that the opposite would happen in this type of situation. When there's a global crisis, we've also had plenty of geopolitical tensions, we've had uncertainty in lots of different local markets, but we've actually seeing an increase in cross-border deals, meaning that corporates are increasingly looking for global opportunities. If we look at the three major regions, we've seen a downtick in activity in the Americas, particularly the US, and instead we've seen much more activity in Europe and in Asia. In fact, six of the largest ten deals in 2020 took place in Europe. And if we look at Asia, it's a very encouraging story because Asia saw the impact of the pandemic crisis first, but they've also seen the recovery much sooner.

    [00:16:04] Despite the collapse in deals in the first half of 2020, private equity was sitting on a lot of very dry powder and was standing ready to deploy that capital.

    [00:16:13] So yeah so there are a couple of key trends, a couple of drivers of the dramatic upturn in M&A activity that we saw in the second half of 2020. And one of the key drivers here is private equity. So back in April, we called up private equity as one of the likely drivers of the recovery in the Corona Correction series. And if we look at the data, we see an increase of 27 percent in financial sponsored backed buyouts. So these are really the transactions that are driven by private equity firms. So interest rates are low, investors are willing to invest in growth and there are plenty of opportunities as a result of the crisis that were not available before. So it's really the perfect conditions for private equity firms to execute.

    [00:17:01] Low interest rates have fueled the late 2020 surge. Rates are set to remain low in 2021, but debts have increased and yields are starting to rise, and this could impact future volumes.

    [00:17:10] So when it comes to the interest rates, central banks across the world have certainly flagged that you know they're expecting to remain in a lower interest rate environment for quite some time, so we're probably not going to see any major impacts now, so that it's likely that debt financing will continue to remain relatively cheap. However, we have had a record year on the capital markets front as well, which means that there's a number of corporates that have refinanced and they have raised additional capital and now are dealing with a fairly heavy debt burden. So the question is, are they going to be able to maintain that going into 2021 or are we going to see an increasing number of distressed companies thereby resulting in distress driven M&A? So I think there's a good chance that we'll see that towards the end of next year. Additionally, we will absolutely see more megadeals next year. And that trend is not going to change where we'll see more private equity. We'll also see technology continue to dominate as a sector.

    [00:18:08] In many ways, M&A echoes the broader financial markets. It's been a boom for companies with access to cheap funding or sitting on cash piles. Large cap corporations with access to capital markets have been in a strong position, but leverage has increased. Meanwhile smaller companies such as family businesses have struggled to remain solvent. Historical returns to large cap companies acquiring other large cap names have been poor. But in a world where passive flows favor the largest listed corporations, the benefits in this cycle may be as much to do with fund flows as they are to do with improving the business model. Big years of M&A have often preceded poor years for markets such as 2000, 2007 and 2019. But as we've discussed before, maybe the influence of central banks can break that historical pattern.

    [00:18:55] And you can now get The Big Conversation from Refinitiv as a flash update on your Alexa device or Google assistant. If you want to know more about how to download it to your smart speaker, please go to Refinitiv.com / flash briefing.