by Roger Hirst
Dec 09, 2020
- Whilst the potential for inflation has been on the rise recently, we still feel it’s unlikely that we’ll see any undesired increase in price levels at least for the next year.
- With inflation risks out of the way, the narrative for fiscal stimulus will drive the reflation case. With that, it’s important to identify the type of reflation we’re expecting. Do we expect reflation to be driven by global economic growth, or by “lower quality” drivers such as fiscal spending and weaker USD? Whilst the impact on asset prices might be similar (higher Emerging Markets and Commodities), the latter narrative is weaker and should make market participants more cautious about their “return to normality” expectations.
- An extended move in bond yields might force the Fed to implement Yield Curve Control, which would cap nominal yields and drive real yields into even further negative territory – a positive backdrop for gold (especially given the recent correction).
- In a reflationary environment, we don’t expect a full collapse in US Tech stocks and we believe that Japan will continue to trade well.
Too Early to Price a Structural Shift?
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:
- How quickly vaccines can be manufactured and then delivered in the first half of 2021
- How successfully governments can bridge the gap with fiscal and monetary support.
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:
- The US Budget Balance (as a percentage of GDP) shows the government’s position with regards to revenue and expenditures. The position has collapsed to a deficit of 15% of GDP, compared to negative 10% during the Great Financial Crisis.
- Total outstanding US debt has exploded higher, pushing the US debt-to-GDP ratio to its highest level in over 50 years.
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 to 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.
Reflation or Inflation?
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.
- It’s also important to clarify that we’re talking about price inflation (i.e. generalized and sustained increased in the level of prices) and not asset inflation, which has already been formidable and is best represented by the increase of equity markets prices.
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).
- We need to acknowledge the risks that higher inflation, fueled by higher savings and supply-chain bottlenecks, could precede any continuation of the reflation narrative. If inflation were to surge before economic growth has picked up, asset markets would be severely impaired as fiscal stimulus, a key driver of the reflationary narrative, would likely be trimmed down given its (further) inflationary potential.
- This knock-on effect of lower growth would be positive for Tech and bond prices (negative for yields) at the expense of reflationary sectors like Emerging Markets, Energy or Financials.
- That being said, whilst the potential for inflation needs to be contemplated, we still believe that we won’t face compromising price levels increases for at least the next year.
- With inflation failing to materialize prior to an actual pick-up in economic growth, allowing for a real reflationary change of regime, what does that mean for asset prices? In the next section we review the potential outcome for the US dollar, bond yields and the implications for technology stocks.
Reflation to drive US Dollar weakness, or the other way around?
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:
- During the last two decades, the DXY fell from 2002-2008, a period in which China led global growth higher through commodities demand and trade with fellow emerging markets. This was a reflationary period after the Dot-Com bust.
- Between 2011 and the present day, global growth was weak, and the US dollar was strong. Capital was sucked into US asset markets, chasing the relative higher yields of US bonds or the earnings growth of the US tech sector.
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.
- The assumption is that the US will spend more in fiscal programs than other regions, thus diluting the US dollar.
- Why should we expect emerging market equities to outperform in a weak US dollar environment? Because there is a clear pattern over the last 20 years in which US equities have underperformed emerging market equities during periods of US dollar weakness (and vice versa).
- A weaker dollar also reflects a loosening of financial conditions in which emerging markets and commodities can thrive. The ratio currently looks like a topping formation. A break of the red support line would favor MSCI Emerging Market outperformance.
Overall, this means that we either:
- Get a return to a normalized economic environment thanks to the vaccines, which drive real economic growth and, thus, the real reflationary narrative we’re historically used to, or
- Get a slower than currently implied return to a normalized economic environment on the back of disappointing news on the vaccines side, which means that fiscal stimulus will be deployed at full-force, which in turn would depreciate the USD (in our opinion) driving reflationary assets higher anyways. That being said, this “low quality” reflation is not backed by economic growth, and market participants should not be overly optimistic about this scenario.
Reflation and Bond Yields
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.
- US 10-Year Government bond yields have been in a well-defined disinflationary downtrend for over thirty years. During reflationary periods, bond yields rebounded to the top of that channel, reflecting the improved outlook for growth.
- Each trip to the top of that trend has usually coincided with a tricky time for risk assets. That risk-off trigger point has been getting lower, reflecting the higher and higher levels of total debts that have built up over this time period. In 2018, the S&P 500 declined by 20% shortly after the US 10-Year yield touched 3.25%.
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.
- Falling real yields have been very supportive of gold prices. The performance of gold has been inversely correlated to real yields for much of the last decade. Gold has recently declined because both nominal yields and real yields have been rising. This is a buying opportunity for investor who think that the Fed will cap yields.
Reflation and Tech Stocks
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.
- Over the last decade, US equities have outperformed almost every other major region led by US technology stocks. The outperformance of the NASDAQ100 versus the Eurostoxx50 is startling over this 10-year period.
- This outperformance has been a self-fulfilling and perpetuating trend (George Soros calls this ‘Reflexivity’) that has sucked capital into the US, driving up the US dollar and US equities, making both look more attractive to foreign investors, reinforcing the cycle.
- Over the summer of 2020, technology stocks also became bond proxies given their limited debt and high cash flow generation, adding further momentum to the trend. When equities were collapsing during March, the mega cap tech stocks quickly found a bottom and reversed, helped by monetary and fiscal intervention. Whilst many real economy stocks continued to collapse, the likes of Apple, Amazon and Microsoft provided the capital protection that was historically the role of the bond market.
- This concentration and acceleration of a longer-term trend means that owning technology stocks was THE consensus trade of the summer by a significant margin. Owning gold was a very distant second.
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 buy backs, 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.
Japan: The Veteran’s Reflation Trade
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).
- After the equity and real estate bubble burst, Japan was plagued by domestic deflation, exacerbated by declining demographics. With no growth at home, Japan was reliant on global growth to drive its export industries, which is why it is highly geared towards reflationary environments. From 1991 to 2012 (the start of Abenomics), the performance of US Yields and the Nikkei 225 is remarkably similar.
- It was not until the onset of Abenomics in 2012, that the stranglehold of US yields on Japanese equities broke.
- But even in the years since Abenomics commenced, there has been a four-year period in which US Yields and Japanese equities re-coupled.
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.