- The reflation narrative has become the overwhelming consensus view for 2021. This implies a weaker dollar, higher bond yields, and outperformance from emerging markets and commodities. As always with consensus opinions, several risks lie ahead of this narrative.
- This reflation is driven by a weaker US dollar rather than synchronized global growth, which makes the narrative fundamentally more fragile and transient. A stronger US dollar is, therefore, the biggest potential headwind to consensus.
- US reflation would generate higher yields in the US, which would lead to capital inflows (capital follows higher rates, risk-adjusted), strengthening the demand for the dollar, pushing its price higher.
- The risk of inflation disappointing is also quite real (explained below), and should they materialize, this would ease pressure on the US dollar and halt the momentum of any reflationary sentiment.
The Risks to the Reflation Narrative
The year of the virus was an extraordinary year for financial markets. Few would have predicted that some equity markets would soar to new all-time highs during the deepest economic decline in living memory and one that is expected to deliver a double-dip recession (a second recession swiftly following the first).
Despite this possibility, the talk for 2021 is not one of higher volatility, market uncertainty, and fears of insolvency. It’s quite the opposite. The overwhelming consensus for 2021 is one of reopening, reflation, and rotation. The prospects for a vaccine, combined with monetary and fiscal support, has created an extraordinarily harmonious narrative. Over the last twenty-five years, there has not been a New Year consensus quite like it.
Below, we explore the risks embedded in this reflation narrative, especially given how consensus it has become.
The Reflation Trade
In the previous Lykeion macro report, we looked at reflation versus inflation. Since then, the reflation debate has continued to gather momentum. This narrative argues that the economy and risk assets are going to outperform in 2021 because policy makers will administer even larger doses of fiscal and monetary policy, whilst the vaccine will reopen economies. These expectations provide enthusiasm around the reflation trade narrative, which broadly encapsulates the following themes:
- A weaker US dollar
- Higher bond yields
- Rotation out of growth (like US tech) into value and cyclical companies (like banks and commodity plays)
- Emerging market equities to outperform developed market equities
- Small-cap and low quality to outperform large-cap and high quality
- High Yield corporate bonds to outperform Investment Grade
- Commodities to soar, led by the likes of industrial metals
In short, 2021 will be a risk-on environment, with growth and inflation underpinned by policy support.
The Type of Reflation Matters
Reflation trades have been performing well, but what type of reflation is this? Two options:
- Dollar reflation is where the US dollar declines first, leading assets that are most sensitive to the weaker dollar to perform well (emerging markets and commodities). The US dollar leads the way, and asset prices follow.
- Globally Synchronized Growth reflation is the inverse, where first, demand for dollar-sensitive assets (like commodities) increases on the back of real economic growth, leading the currencies of commodity-exposed countries higher against the US dollar. In this case, the weaker dollar is a consequence of the increased demand for commodities on the back of higher economic activity.
We’re currently in a Dollar reflation environment (1), and the risk with that narrative is that this kind of reflation can be significantly more transient and short-lived than Globally Synchronized Growth reflation (2).
When the dollar falls, the S&P usually underperforms the MSCI Emerging Markets. When the dollar rises, the S&P outperforms the MSCI Emerging Markets.
A – During the period from 2002 to 2008, China exploded onto the global landscape with an insatiable demand for commodities, leading to a period of synchronized global growth in which demand for raw materials and finished goods underpinned the outperformance of emerging markets (driving demand for EM currencies at the expense of the US dollar). This dollar weakness helped make commodities (many of which are priced in US dollars) cheaper, further increasing the demand for commodities in a self-reinforcing trend also known as Soros’s reflexivity.
B – There was a secondary, smaller period of synchronized global growth reflation from 2016-2017. China was again central to the rebound in economic activity after the commodity bust and industrial profits recession of 2014-2015.
C – Fast-forward to today and we can also see the US dollar is declining. Emerging markets have indeed been outperforming the S&P500, but that outperformance has been lagging the weakness in the US dollar. Why?
Because we’re in a Dollar Reflation (1) and not in a Globally Synchronized Growth (2) environment. A weaker dollar, and not a fundamental improvement in demand (stronger economy), is driving reflation assets higher. The lag might be an indicator of how little global growth there is in the world.
- Much of Europe is going back into a coordinated lockdown, in many places more severe than in 1H 2020, and certainly more widespread. OPEC is cutting production because there’s no growth. US gasoline demand (a proxy for activity within an economy) is still 14% below last year’s levels according to official EIA data. Airline flights have not recovered. In the UK, flight corridors are being shut down for the first time during the pandemic.
- When we look at the ratio of silver versus gold, we can see that silver has outperformed since the middle of last year, but it has not made new highs since August. Whilst some of the lacklustre performance may be due to the inflation expectations overshoot last year, it should still be surging if industrial demand was robust given that silver is a precious metal with many industrial applications whilst gold is seen more as a reserve asset.
- European equities have been similarly unimpressive. The Eurostoxx contains many companies which are reliant on exports, particularly to emerging markets. The Euro has been performing well (a headwind for exports), but if emerging market demand was indeed robust, this would have offset the impact of the currency (and the Eurostoxx would have performed better than it has). There was a surge on the back of the vaccine headlines for a few days in November, but since this one-off impact, the Eurostoxx has made very little impression versus the S&P500.
There are very few signs of real economic growth on asset price performance. Instead, asset prices are focusing on US dollar weakness.
- The classic dollar sensitive plays have been outperforming on the back of the weaker Dollar Reflation (1) trade. The chart of the KOSPI200 (Korean equity index) and copper have been moving in lockstep for years, but have performed well since this narrative gained momentum. The driver is the weaker dollar, pushing reflation assets higher, with the speculative community chasing that momentum trade.
- We can also see this in investors’ positioning. Net non-commercial (i.e. speculative) positioning in copper futures has recently touched an all-time high.
- Speculative positioning in the Euro has drifted from its all-time high but remains elevated on a historical basis. Over the last 20 years, when positioning has reversed from these extremes, it has often seen a 5%-10% reversal in the Euro.
Dollar Reflation may eventually transition into synchronized global growth reflation, but in its initial phases, dollar reflation is far more transient, driven by fast-money flows (what’s happening right now) rather than by long term economic trends.
What could end this weaker US dollar reflation narrative, given it’s based on unsteady ground?
- Successful US reflation
- Weaker than expected inflation
Successful US Reflation
A successful US reflation (i.e. higher bond yields) could also become a self-correcting mechanism. We have already seen US yields rise above 1% for the first time since March 2020. This could lead to several different scenarios:
- If US yields continue to rise whilst other global yields, such as the German Bund (10-year bond), remain anchored, then the differential between the two (i.e. the spread) will begin to widen out. Eventually, this will make US bonds attractive again to foreign investors, leading capital to flow into US markets (driving the US dollar higher).
- If US yields rise unchecked (big IF), they could destabilize global equity and emerging markets assets, which would force risk-off sentiment (driving the US dollar higher). We saw an example of this at the end of 2018, when US 10-year yields reached 3.2%, ringing the bell on the equity rally. Risk assets were unable to tolerate higher yields then. That tolerance level is likely to be much lower today, given the huge increase in debt across all sectors of the global economy during 2020.
- Somewhat paradoxically, if US equity markets continue to perform sufficiently well, it will also suck in foreign capital, especially from Europe given its lacklustre performance. This would, once again, provide support for the US dollar as investors initiate a round of profit-taking on the speculative flows that have chased the reflation trade.
Weaker than Expected Inflation
Two narratives challenge the higher inflation outlook that has become somewhat consensus by now: a reversal of the growth in money supply and the substitution effect of demand.
- One argument at the core of the higher inflation narrative (which supports the reflation trade) is the rise in monetary supply (as discussed previously, we should not consider inflation without growth to be reflation…. inflation without growth is stagflation). The monetary base (M1 and M2) has seen a stunning increase during 2020. Compare this to previous years during which QE was also in operation. The difference is stark.
- The rise in M2 is considered to have huge inflationary potential, but part of this spike is due to corporates drawing down their emergency credit lines and putting these into deposit and checking accounts. Furthermore, furloughed workers who continued to receive wages, have also been increasing their savings. Combined, these have led to a surge in money supply, but this may be transitory. If demand has actually held up better than expected, then corporates may choose to return their emergency credit lines. The spike in M1 and M2 may therefore be transient.
- The other argument that supports a weaker than expected inflation outlook is the “substitution effect”. During the lockdown, we have substituted service consumption for finished goods and commodities consumption. We have cooked at home rather than eaten out and renovated our kitchens rather than go on vacation (unless you’re anything like us who don’t own homes and permanatnely live out of backpacks). This is demand that has been brought forward and will not come back (we only need one new dishwasher).
- When we eventually emerge from lockdown, we will return to the consumption of services. Goods and commodity demand may fall just at the point that producers, who are finally overcoming their supply chain bottlenecks, start to ramp up supply. This could put downward pressure on prices.
- The reflation narrative has a strong foundation based on asset price performance.
- Fighting the consensus is often a losing battle BUT being ready to react is key.
- We’re currently sailing through dollar reflation, not synchronized global growth reflation. Dollar reflation may become growth reflation, but the transition could be tricky (if it materializes).
- Remaining open to the possibility that the narrative could quickly transition into one of low growth, insolvency and lower yields paired with a higher US dollar, before policy-makers crank up the fiscal and monetary support once more, is the best hedge for a portfolio.