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The villain often receives what looks like a mortal wound when the film still has 10 minutes to run. You yell “HE’S NOT DEAD” at the screen but the hero doesn’t know how movies work, and is surprised when the blood-soaked murderer staggers, inevitably, back into the frame.
Which brings us to the reflation trade, which was cut down by a barrage of little blue dots last week. But Monday came and cyclical stocks, the trade’s primary beneficiaries, were aaaaliiiivvvvveee. Here are financials, industrials and energy stocks on the day, all beating the S&P:
There is probably some technical reason for this bounce, it’s just one day, and it could be nothing but the dying twitches of the growth/inflation/buy value/sell growth/sell duration idea. But given this newsletter’s view that the Federal Reserve remains very dovish, and that just a few days ago we were all quite focused on inflation, it seems like a good time to check in with rising prices and the great asset rotation they were meant to bring in their wake.
Note, first, that lots of indications of inflation and inflation expectations — in actual prices and in investors’ positioning — came off the boil before the Fed scared everyone last week (by stating the obvious). I have already written about lumber. High housing prices seem to have done what they are supposed to do, and cooled demand there, too. A couple of other good examples. The US bank trade (banks love a bit of inflation) peaked a month ago:
And copper, that prince of economically sensitive industrial metals, rolled over at the beginning of June:
This, paired with the fact that the current quarter is expected to be the peak in GDP growth, certainly makes you wonder how long the reflation trade has to run.
Oliver Jones of Capital Economics gave a sort of reflation trade scorecard in a note released Monday. Against the persistence of the reflation trade, he notes:
Growth expectations are now about as high as they can get
Commodity prices are set to ease further, as oil supply increases and Chinese metals demand softens
In favour of the trade enduring, he lists:
US inflation, especially in wages, looks a bit sticky and could push US long-bond yields up over time
Antitrust enforcement and tax policies are changing ways that will hurt the Faang growth stocks
Value stocks are historically cheap compared to growth stocks, as this chart shows:
I have been waiting for valuations to matter for so long that I feel like Linus van Pelt waiting for the Great Pumpkin, but that’s still an impressive chart. Jones concludes that the reflation trade is “down but not out” and financials and industrials, if not energy and commodities, are still poised to perform well.
Something else to add to Jones’ list. The economist George Magnus, late of UBS and now at Oxford university’s China Centre, emailed me with the following thought about supply constraints:
If there is a regime change going on in terms of inflation, the last place we’d expect people to see it is now, whilst it’s just getting going . . . As our economies reopen in the wake of vaccinations, and pent up demand manifests itself, we’ll see some transitory price inflation, to be sure. But the supply constraints that are permeating the global economy will linger for longer. Some are rooted in the supply chain changes and supply constraints generated by the increasing geopolitics of trade and technology on both sides of the Pacific, and beyond. Some are still Covid-related, most recently threats arising from outbreaks in and around large Chinese ports. Yet others can be found in the commodity complex.
If you are looking for examples of the constraints Magnus is talking about, consider this fine column by Bloomberg’s David Fickling about container shipping. He points out that:
The freight industry has been cutting back on investment in anticipation of a global economy in which trade would be playing a smaller role. Since March 2019, Maersk’s capital investment has come to just $2.9bn, not much more than it invested in a single quarter during 2014 [Maersk is the biggest of the container shippers]. That’s a problem that will take years of building new ships, berths and port loading cranes to fix.
Regular readers will remember that I am a bit of an inflation sceptic. But if you were willing to bet on the reflation trade before the Fed meeting last week, surely there is reason to stick to your guns now.
The reflation trade may, however, bear the seeds of its own destruction. If growth and inflation persist, the Fed is going to respond, at least verbally. As we saw last week, the market will respond to this. And if it responds dramatically enough, that could kill the market and growth. As Ray Dalio, manager of the world’s biggest hedge fund, Bridgewater, summed up the problem on Monday:
It’s easy to say that the Fed should tighten, and I think that they should . . . But I think you’ll see a very sensitive market, and a very sensitive economy because the duration of assets has gone very, very long. Just the slightest touching on those brakes has the effect of hurting markets because of where they’re priced, and also passing through to the economy.
The economist Andrew Smithers recently put it to me in plainer terms: “Tightening monetary policy sufficiently to hold inflationary expectations in check will probably cause a stock market collapse. The Fed is therefore hoping that inflation will go away.”
One good read
In a recent column, my colleague Mike Mackenzie takes up the position opposite the reflation trade, discussing the possibility that we are headed towards a growth disappointment, as fiscal stimulus slows, higher taxes threaten, and debts weigh. It is an under-appreciated possibility I will write about in days to come.
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