Vaccine headlines saw asset markets emphatically reach for a reflation narrative (see Vaccines for Reflation). Could the price action in November herald the start of a structural shift in markets? For regime change to be sustained, it will depend upon:
A true reflation narrative, if sustained, would have significant structural consequences for asset prices and investor’s portfolios.
The biggest change we’ve seen in the last year is that fiscal has come into the equation with quite a powerful voice. The pandemic has led to a convergence of policy where, despite the political differences, the economic response of both sides of the political isle to Covid in the US election would have been similar. There has been a global policy shift away from the monetary toolbox of interest rates and quantitative easing (QE), and towards the levers of government expenditure, in which monetary policy plays a supporting role (rather than taking the center stage) to this fiscal authority.
The outcome of the US election wasn’t going to define whether there would or would not be a fiscal response. That was already baked into the cake. The election only influences the size and the speed of that response.
So far, fiscal policy has already been extremely loose:
These levels of relative government expenditure have not previously been seen outside of a ‘war’ footing, but the economic disruptions are of such magnitude that it’s very likely that the government will still need to do more. US GDP rebounded in Q3 but remains below its peak, with the likelihood that GDP will roll over again during the winter months as lockdowns increase across the world until the vaccine becomes a reality.
Throughout 2020, fiscal policy has often been described as ‘stimulus’. Asset prices, particularly equities in the US and parts of Asia have made new highs, but economies remain strained. Governments are still providing emergency support through wage and benefits schemes. Economies have rebounded, but they have not recovered to their pre-COVID levels.
The chances of a double-dip recession (contraction, followed by growth, followed by another contraction) have significantly increased in the last month as the second wave materialized, forcing governments back into rescue mode, extending their support packages. Fiscal policy is loose, but is it loose enough? We don’t think so.
In the meanwhile, the US is still administering the previous support packages, meaning that it’s unlikely more support will be forthcoming until after the Presidential inauguration. A bipartisan agreement will eventually be reached because the impact on the economy warrants it, but the process has lost some urgency.
European support is even less likely to accelerate in the short term. An emergency relief fund had already been agreed in July 2020 and the frugal five (Germany, Demark, The Netherlands, Finland and Austria) are unlikely to entertain a top-up package unless the economy is once again in a vicious downward spiral.
In the short term, therefore, it will again be the role of central banks to use monetary policy as a sticking plaster, whilst the politicians take their time to grind out a cohesive fiscal strategy. That strategy, when it arrives, may be more inflationary than reflationary.
If you listen today to many analysts talking about 2021, reflation and inflation have become interchangeable. We should, though, make a distinction because reflation or inflation could have wildly different outcomes for asset prices.
Reflation is the expansion in the level of output of an economy by government stimulus, using either fiscal or monetary policy, which seeks to boost the economy back to the long-term trend. The meaning of “Reflation” usually equates to a recovery, although over the last 20 years it has also described periods in which growth has been above trend.
Reflation is economic growth, and it can occur with or without ‘inflation’ (although prices are usually recovering during reflationary periods when governments are stimulating demand). Inflation can also occur without economic growth (i.e. stagflation), meaning that whilst reflation and inflation tend to walk hand in hand, that doesn’t necessarily have to be the case.
In previous editions of our Macro prints, we outlined the inability of monetary policy (i.e. lowering of interest rates and QE) to create inflation over the last decade. US CPI has been relatively benign, bouncing between 0% and 3% throughout this period of massive expansion in the Fed’s Balance sheet.
This period of balance sheet expansion also saw the velocity of money collapse.
Despite the massive stimulus, there was little price inflation risk because the US central bank doesn’t create money. Instead, it creates reserves at commercial banks, and if those reserves are not converted to loans because the banks are too cautious or their customers don’t want to borrow (this is in fact what happened), then the stimulus doesn’t reach the economy, lowering the risks of price inflation.
Since we’ve entered the world of fiscal support, price inflation has become a more realistic risk as money now reaches the economy more directly than through previous periods of monetary stimulus.
In the US, the government has provided wage support and commercial banks have been given government guarantees for some of the loan programs, which has removed one of the barriers to providing loans.
Furlough payments coupled with lockdowns has given rise to a massive increase in personal savings (something that contrasts from previous periods of QE) as people have money but can’t go spend it like they used to.
This has not (yet?) been inflationary given the lethargic Velocity of Money (as seen above).
Whilst these savings may be for a rainy day, to pay down existing or future expected impairments (such as loss of future income), they do represent an inflationary potential during future bouts of economic strength. The velocity of M2 has started to bounce back (albeit from a very low base), and we think that it’s important to stress this inflationary potential which contrasts with historical observations that measures of inflation usually decline during and after a recession.
Topping up the explosion of savings is the severe disruptions to supply chains and inventories that have been in decline until recently, which also represent an increased risk of inflationary bottlenecks (i.e. supply-chain disruptions end up creating shortages that drive up prices of the goods related to that supply chain).
How should the dollar perform during a reflationary period? We have previously discussed the framework of the US dollar smile. The dollar index (DXY) carved out a ‘smile’ in 2016.
The US dollar tends to be strong during periods of weak global growth or severe risk off scenarios (flight to safety), like at the end of 2015 when the global economy was suffering from a commodity shock and industrial profits recession.
The US dollar tends to also be strong during periods of US economic outperformance (actual or perceived), like at the end of 2016 when Trump’s election and the US-centric narrative drove the US dollar to its highest level in this DXY cycle.
The US dollar tends to be weak when there is synchronized global growth. If the global economy is firing on all cylinders, then the higher beta emerging market and commodity currencies should outperform, like in mid-2016 when there was a reflationary environment provided by an extensive credit injection from Chinese authorities.
The USD smile also works for longer-term charts:
Based on this framework, it would be fair to think that if a vaccine were to be successfully introduced and distributed in 2021, then a global rebound should put downward pressure on the US dollar.
But even if the vaccine narrative doesn’t materialize (i.e. even if we don’t get real economic growth as a result of the economy getting back to a normalized level of activity), the weaker USD could still persist simply on the back of US fiscal policy (it is a crowded trade, but we still feel it’s the right one given the circumstances). The result of that would be a “lower quality” reflationary narrative, as instead of being backed by real economic growth, it would be backed by fiscal stimulus and lower USD, which is positive for commodities and Emerging Markets assets.
Overall, this means that we either:
Where should bond yields go during a period of reflation? The obvious answer is that they should go higher. They did briefly surge on the day of the vaccine announcement, but if a weaker dollar is the poster child of a reflationary environment, then bond yields are the potential banana skins whose role is to derail any outsized movement towards an excessive reflationary environment.
The level of bond yields matters for risk assets. Today, the top of the US trend channel is around 2%. An economy in which government debt-to-GDP is north of 130%, corporate debt-to-GDP is at record levels and household debt-to-GDP has turned sharply higher, is unlikely to withstand yields anywhere near that level.
The US Federal Reserve may have to step up its bond-buying program in order to cap bond yields. As we can see from the chart below, the Fed is currently active with QE, but historically, “active periods” of Central Bank buying have seen bond yields consolidate and move higher, which is the opposite of what you would expect. That is because the market moves ahead of the actual purchases of Central Banks, and as such, between the time QE is announced and it actually starts, the market has already priced the monetary program in.
The Fed may therefore have to specifically target a fixed level of bond yield through a process called Yield Curve Control, where they target treasury purchases of certain maturities (i.e. 5Y or 10Y bonds) to control its yield (i.e. keep it low enough to encourage more borrowing). We may have little idea of either the market or Fed tolerance levels for higher yields, but it’s unlikely to be much higher from here.
If yield curve control is implemented, then bond yields would underperform inflation during a reflationary environment because Central Banks would not allow yields to make excessive moves. If yields are capped whilst inflation rises, then real yields (the return to an investor in excess of inflation) would fall. US 10-Year real yields are already in negative territory.
Value and growth are a constantly changing constituency of stocks, but for today’s purpose we can think of value as the beaten-up sectors which now look historically cheap, such as energy and financials (particularly the banks). Many of these stocks are also cyclical stocks that will perform well when there is economic growth (reflation).
Growth stocks are something of a misnomer in this context. They are not the type of stocks that necessarily like economic growth, but they are the stocks that can grow their earnings even when economic growth is sluggish. In today’s market, US technology firms have been growing their earnings during periods of sluggish growth, and the COVID crisis has only accelerated and concentrated this trend.
Could reflation therefore lead to a rotation out of these growth names and into the cyclical and value laggards, thus undermining their massive outperformance? The value heavy US mid-cap sector is starting to motor, and there is a significant amount of outperformance from earlier in 2020 to play for, as can be seen in the chart below.
But are investors really going to start dumping the mega cap tech names? A rotation requires active managers to be in control, rotating from one sector to another based on valuation. By now it should be clear that that’s not the case, as the framework is dominated by passive and model-based funds using substantially different investment criteria.
If bond yields are capped by central banks, then low volatility growth names like the FAAMG cohort, which still have cash on hand for substantial buybacks, can continue to rise. As noted in our Charts of the Month newsletter in November:
“It’s generally accepted that stimulus will not end, and passive flows are here to stay. Why does the music have to stop anytime soon, especially in a year in which we danced so little?”
The tech stocks may underperform the value and cyclical names if we get a period of genuine reflation, but that doesn’t mean we should expect their prices to collapse. Tech stocks, like bond yields and the US dollar, could all change direction if there is true reflation during 2021. It’s not, however, in the interest of any central bank to allow a rise in volatility. They will be watching to ensure that any trend change, should it occur, remains orderly.
Developed Asian equity markets, with an industrial bias (and a large dose of technology stocks), have performed incredibly well since the election. Korea and Taiwan both made new highs (Taiwan breaking the highs it set over thirty years ago).
Japan still remains well short of the record high that was set in 1989, but in US dollar terms, the Nikkei 225 is closing in on those levels.
Japan is a veteran of the reflation trade. It’s the developed market that macro funds used to turn to during times of synchronized global growth.
For an equity market that was in a 20-year downtrend, that might not seem obvious, but there are clues of the reflationary profile of Japan in the comparison of the Nikkei225 and the US 10-Year yield. From 1991 to 2012 (the start of Abenomics), the performance of US Yields and the Nikkei 225 is remarkably similar (the following chart has been rebased to 100).
It may have become obscured by Abenomics and ignored by the runaway success of the US mega-cap tech names, but Japan’s equity market remains a reflation play today. If global fiscal and monetary policy combines to create a genuine stimulus that drives a recovery (rather than just provides support), then Japan should continue to blossom.
If we get global growth and the suppression of yields through central bank intervention, then the Nikkei 225 should join Taiwan and Korea in making new all-time highs, not just in US dollars, but in local currency too.
Japan remains a clear and simple reflationary play if 2021 manages to move through the recovery and into the growth phase.