Is the reflation trade over? Investment opportunities for 2021 and beyond
Article originally published on: https://financialfortify.com/opinion/is-the-reflation-trade-over-investment-opportunities-for-2021-and-beyond/
Performance of main asset classes: Jan-June 2021
The first half of 2021 is already well behind us! The following chart shows the developments in the most prominent asset classes since the start of the year:
From January to June, stocks continued to power forward, but the asset class which outperformed were industrial commodities, notably oil, lumbar and copper. This is consistent with economic reflation following the 2020 recession, although this time round, the widespread restrictions caused profound supply shortages which caused substantial price hikes.
The Dow Jones index comprises well-established industrial firms which, at any point in time, may trade at a cheaper price than they are actually worth. On the other hand, the Nasdaq includes companies which are at an earlier stage in the business life-cycle and hence have better growth prospects but also more risk. This resulted in the Dow Jones industrial index to outperform the tech-heavy Nasdaq for most of the six months. Therefore, the so called “value stocks” outperformed “growth stocks”. Why? Investors’ fear of inflation played a huge part. You can find out more here.
Bonds, proxied by TLT, fell by almost 8% till the end of June. When investors expect inflation, assets which provide a fixed stream of future repayments are undesirable because these cash flows get diluted, so investors sell their bonds and scramble into other assets which can beat inflation.
But bond bulls were not the only ones which endured losses; Even crypto fans ended the first six months under the weather. After an exuberant first few months which saw Bitcoin skyrocket 98.6% since the start of the year, a few consecutive negative media headlines (China clampdown, Elon Musk tweets and ESG concerns) caused it to retrace a significant amount of its gains, bringing the entire crypto market down with it in the process.
But the most discontent of them all must be the gold bugs. Despite emerging inflationary pressures, gold underperformed significantly, losing nearly 9% since the start of the year. Contrary to popular belief, although precious metals like gold retain their value in an inflationary environment, it is important to understand that movements in the prices of these precious metals are more a function of the dollar and real interest rates.
Here is a tabular summary of the six month return from January to June as well as the highest return reached by each asset class throughout the six month period.
As you can see from this table, US equities ended June close to their all time highs and these optimistic developments continued through the beginning of July. But how did other markets perform? During the first quarter of 2021, the dollar weakened as the reflation narrative picked up pace, causing emerging markets to outperform developed markets. Emerging markets are highly vulnerable to dollar increases, because most of their debt is issued and serviced in dollars.
Upon the start of the second quarter of the year, a fresh wave of coronavirus cases in emerging economies compounded with a brief period of dollar strength caused the emerging markets to retrace a significant amount of gains.
As the dollar retraced its gains in around mid-May, capital flowed into emerging markets once again, before the FED ruined the party with its tighter policy announcement in mid-June, which caused a significant spike in the dollar and weighed on emerging market performance.
Here is a chart depicting the performance of some key regions:
When it comes to the currency markets, the dollar showed mixed performance. The Japanese Yen was the worst performer losing almost 8% against the dollar, followed by the Euro and the Swiss franc. The losses in the latter two currencies were mostly derived following the FED’s tighter policy announcement in June and was substantiated when the ECB president mentioned that they will lose policy for longer.
What happened to the markets since June?
The markets are at an interesting juncture because there may be initial signs of a shift in the reflation narrative. What makes it even more interesting is that the consensus seemed to be certain that we are in economic reflation, meaning that everyone is positioned on the same side of the boat. This speaks opportunity for the contrarian investor!
The first catalyst underlying this shift in narrative was the Federal Reserve surprisingly announcing two premature interest rate hikes in 2023 during its June meeting. This shifted the markets’ perception from one that was fearful of runaway inflation to one that inflation may be transitory. This is because economic growth cannot be sustained if the FED tightens its monetary policy, so inflation will also not be something to worry about over the medium term.
Since the start of 2021, the spread between the 10-year yield and the 5-year yield widened significantly. Recall that the yield moves inversely to bond prices, so this means that investors were unwilling to hold longer dated bonds (because in the presence of inflation these will lose value). However, US medium and long term inflation expectations started to recede from mid-May, but this trend reversal was amplified in June upon the announcement that the FED was thinking about tapering its policy. This narrowed the spread between the 10-year and 5-year bond yields. Because the market now deemed inflation to be transitory and discounted the fact that growth may slow in the future, the yield curve flattened.
Further substantiating the potentially lower future growth narrative has been the rapid resurgence in global COVID-19 cases. The risk that the escalating cases affect economic activity will weigh on the performance of value stocks and will most likely cause so called “stay-at-home growth stocks” like Zoom and the FANGs to outperform.
The confluence of these catalysts led to an acceleration in prices of growth stocks (proxied by ticker VUG) and a modest retracement in some value equities (proxied by ticker VTV) towards the end of Q2:2021. This shift in narrative closed the performance gap between value and growth stocks.
Moreover, as investors became more skeptical about the growth outlook, they sought safety in the US Treasury market. The 10-year bond yield, which moves inversely to price, declined to 1.2% for the first time since February. This flow into US bonds was a partial cause for a gain in the dollar, which in turn weighed on Bitcoin and gold. In this article, I provide a brief explainer why the dollar is crucial to monitor and in this article I explain how currency movements affect the value of assets.
In the following table, I reproduce the above table and also include the performance of major asset classes since June.
Is reflation turning into stagflation?
It is still quite early to conclude with confidence that the reflation narrative is over.
Some lagging economic indicators like inflation data in the US have shown no signs of receding. These strong increases in US consumer prices continue to leave the market pondering whether the FED will pursue (or even bring forward) its policy tapering timeline.
But on the other hand, leading indicators as well as some lagging economic indicators in East Asia suggest that peak growth has been reached.
US consumer confidence reached its lowest level since February, as inflation concerns spoiled consumers’ spending spree. Besides, loan growth remains weak and this suggests that the potential for natural creation of new money is weak. Meanwhile, velocity of money remains subdued, while debt levels remain high.
The fact that US stimulus programs wear off in September with employment far from its pre-Covid levels all suggest a deceleration in GDP and inflation. Even FED Chair Jerome Powell himself reiterated that inflation is foreseen to be transitory and the economy must make “substantial further progress” until the FED pursues any form of tapering.
High frequency indicators in China are already showing signs of weakness, while GDP growth missed expectations, and this slowdown is likely to carry forward into the developed world. European price pressures seem to have already maxed out and the rapid spread of the delta variant is bound to cause further growth impediments going forward.
A couple of further economic data points in August/September should give us a more clear indication as to whether the recovery has further legs. But my suspicion is that fears of yet another wave of Covid-19 cases will weigh on business and consumer sentiment in the developed world. This may lead to some jitters in the markets, just as we are witnessing throughout this week.
Until there is further policy certainty, there may be some volatility in the US markets, with investors shifting from growth to value stocks and from equities to bonds, which will also have an effect on the dollar. And in the absence of an announcement of further economic stimulus, Bitcoin and gold are also likely to face some short term headwinds.
What could go wrong?
Well, a lot of things. But these are the eventualities which will surprise me the most:
1) Inflation getting out of hand and not showing signs of slowing down towards the end of the year. In this case, you’ll find all you need to know about how to inflation-proof your portfolio by clicking this link.
2) An uncontrollable resurgence in Covid-19 cases to the extent that economies fall back into recession. In this case, we’ll experience 2020 all over again, but this time there will be blood in the street as Central Banks have limited ammunition left to stimulate, and Governments are unlikely to provide a stimulus of size comparable to that provided in 2020. The market may experience significant losses in response, and although during busts like these you’ll feel devastated and tempted to cut losses, I’d prefer to use the cash handy to build up positions.
Markets are unlikely to fall significantly unless the liquidity shock transforms into another financial crisis, and governments are unlikely to let their economies dwindle. And that is why the potential policy response also needs to be factored in when making your short term investment decisions.
Investment opportunities for 2021 and beyond
Unless there is a major sell-off, large and mid-cap US equities are still at valuations which do not justify building a position. There may be opportunities in US small caps, however these equities do remain vulnerable to a sell-off as Covid fears pick up.
If you have the time and knowledge to cherry-pick promising small-cap names, make sure you understand the business model of the companies you are interested in, their growth prospects and ensure they have a sound balance sheet and a strong cash balance.
Outside the US, there are ample opportunities. While I am less a fan of the European region, China is one area which deserves attention. Since the start of the year, Chinese equities have underperformed drastically, particularly due to tighter monetary policy by the Chinese Central Bank, more stringent treatment of tech monopolies by the Chinese government as well as accusations by the US of cyberattacks. However, China’s economic growth potential is significant, especially in technology.
Another market which is heavily undervalued in my opinion is Russia, although other emerging markets like India, Taiwan and Saudi Arabia all have demographic tailwinds and will be definite long term outperformers, but they may be prone to a minor correction if the dollar sees further strength.
Moreover you may also structure your portfolio using themes. Here are a few long term (5–10 year) plays you may wish to consider.
- Industrial commodities: the remarkable performance of commodities since the March 2020 crash has been a function of: 1. easy monetary policy, 2. supply unable to meet the surge in demand, and 3. speculation. Although for cyclical commodities, supply will eventually catch up with demand, there has been a significant underinvestment in commodities like copper over the past decade, which is likely to cause a structural supply shortage. There is no sign of demand waning especially when governments are backing a global shift towards commodity-intensive ESG investments. This suggests future tailwinds in the likes of copper, uranium, cobalt and lithium.
- Tech, particularly health-tech: since the start of the millennium we’ve witnessed huge efficiency gains in production processes thanks to technology. Technology has insane future potential, especially given that the pandemic has accelerated the adoption of certain networks. You may want to consider a couple of 5G and cybersecurity firms to include in your portfolio. Imagine the ground-breaking benefits that can be reaped when applying tech to healthcare! We’ve already witnessed the outstanding capability of some healthcare firms to develop a vaccine in 9 months! Genomics, medical cannabis, and psychedelics are three themes on my radar.
- Bonds: Yes, bonds are boring! And yes, bonds do not do well in an inflationary environment. However, it is important to understand that the global financial system is super fragile. One minor unprecedented shock like we experienced during the beginning of this week and we’ll likely witness a flight to safety into US long term treasuries. Moreover, compared to other regions like Europe and the UK, the US is one of the few developed economies which offers a positive yield on long term bonds. This means that the potential for asymmetric price appreciation in US bonds if a risk event materializes is huge. If you are not comfortable holding bonds in an inflationary environment, you can always use options to express your view.
- Precious metals: Currently, precious metals are unloved because the trajectory of real yields is still uncertain. If growth indeed slows and real yields recede, then gold and silver should see some decent upward price action, which is likely to compound if governments provide further rounds of stimulus. Silver has more upside relative to gold.
- Bitcoin and crypto: Cryptocurrencies are a bet against the current fiat-based financial system. They should do well in instances when there is extreme money printing and network adoption. As long as the central banks sustain their loose monetary policy, this will be bullish for cryptocurrencies. Because the extreme debt burdens leave them with no choice but to keep liquidity conditions easy, over the long term cryptocurrencies should do well.
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