The Risks to 2021 Consensus Outlook

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.

The Risks to 2021 Consensus Outlook

Key Takeaways

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:

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:

  1. 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.
  2. 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.

Consider this:

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.

Consider this:

There are very few signs of real economic growth on asset price performance. Instead, asset prices are focusing on US dollar weakness.

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?

  1. Successful US reflation
  2. 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:

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.

We elaborate:

Be Prepared

Published in: Markets
Roger Hirst

Leads all Macro research and content. Previously equity derivatives hedge fund sales and Delta-1 basket flow trading.

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