- Short-term vs long-term inflation expectations are telling two different stories about the fundamental strength of the economy. We believe inflation will pick up in the short term due to pent-up demand and base effects, but also expect that acceleration to quickly fade throughout the year.
- Consumer demand might also disappoint as the surge in savings could be allocated not only towards consumption but also debt repayments (as debt holidays end). We’re a bit less sure about this one though – households are in desperate need of normality, and will likely over-spend once the world reopens.
- Positioning against the US Dollar is extreme right now and a 5%-10% correction could significantly damage the strength of the reflation trade (which is driven by weaker dollar rather than economic growth).
- Could lower equity markets allow us to focus on allocating capital towards the real economy, thus generating real economic growth, instead of speculative activity on capital markets?
US CPI remains at the bottom of the last 50 year’s range (ignoring, for now, the endless debate about whether CPI data is accurate or not), and the mild increase we’ve seen is mainly due to rebounds from low commodity prices and the impact of supply chain bottlenecks, which should not be considered sustainable.
Base effects will start kicking in next month, leading to higher headline inflation numbers, only to wear off throughout the year as base effects fade off. Commodity producers can also adjust supply to higher commodities prices (justified by the comeback of demand). Both dynamics tether inflation in the medium term.
The short-term rise in CPI is more technical rather than sustainable. Central banks will look through higher levels of short-term inflation and focus their policy decisions on the (still challenged) long-term outlook, which is likely why we’ll continue to see accommodative policy going forward.
That is also the opinion of market participants, by the way. The US market is far more convinced about short-term than long-term inflation (or growth). The difference between the 30-year and the 5-year measure of inflation expectations has just reached a 20-year low. The current drop is quite startling, and we now expect higher inflation in the short-term than in the long-term (the ratio is in negative territory).
If market participants were really convinced about the likelihood of a prolonged period of true inflation, it should show up more readily in the longer-term expressions of that metric, but it hasn’t.
We should also compare US and European inflation expectations. Both have been rising, but they have been rising at a much faster pace in the US than in Europe, meaning that the market is pricing the short-term inflationary effects of a lower US Dollar rather than synchronized global growth.
Can the US really experience true inflation if the rest of the world is still battling disinflation and deflation?
The reflation trade is banking on a resurgence of pent-up consumer demand, driven by the recent rise in savings (fuelled by fiscal programs and lower spending due to lockdowns).
The US Personal Savings Rate as a percentage of disposable income is still elevated. The current level of 13.7% is higher than other periods over the last forty years except for last year’s all-time high above 30%.
The increase in cumulative personal savings in the US is approaching $2 trillion since the pandemic began. Savings have also increased across Europe. This represents significant consumption potential once we re-open.
The irony of normality, though, is that invoices will need to be repaid in full. Debt holidays will end, and the jobs market will lose its support. The current level of employment in the US is still a long way from the pre-pandemic levels.
One should also ask himself if the rise in savings has been equally distributed? We think that’s unlikely to be the case. Many of the poorer citizens started the pandemic with little or no savings (40% of US households had less than $400 for emergencies) and have likely remained this way today. Those savings might be sitting in bank accounts that already had discretionary potential (wealthier households decreased spending by 17% vs 4% for lower-income households), and as such, its deployment should be less meaningful in driving demand higher.
A rise in personal savings does not necessarily mean a rise in future spending. If we pair this with a reaction of suppliers to higher prices (increasing supply), then arguments in favour of reflation look less convincing, at least on a longer time frame.
Once life normalizes, will consumers be inclined to return to service-based consumption patterns? The demand for finished goods that has been brought forward (eating out became home cooking, holiday savings were spent on home improvements) pushed prices higher as supply chains were constrained. What if suppliers decide to capitalize on those higher prices, by increasing supply, right when consumption reverses back to services rather than finished goods? To that, one should add that China is patiently waiting for consumer markets to fully reopen to once again export their goods (i.e. it’ll export deflation). We could see a flood of goods hitting the market with little demand to justify it, having deflationary consequences.
We believe the narrative of consumer demand fueling reflation may be overdone. There is pent-up demand, and it should be relevant in the short-term, but given the recent price action in risk assets, it may disappoint what the current expectations imply.
That being said, we acknowledge how desperately households want to go back to normality, and as economies re-open we’ll likely see great enthusiasm for all the services and experiences we didn’t have in the past year. We’ll be monitoring Israel (the country with the most advanced vaccination program) and look for cues that could point us to what the world might look like this summer.
The Dollar and Positioning
US Dollar weakness is at the center of the reflation trade. There is a powerful logic to the case for a weaker dollar:
- The US has been running the largest budget deficit of any major economy, both in relative terms (as a percentage of GDP) and absolute terms (still being the largest economy).
- The US, therefore, stands as the world’s most fiscally aggressive nation.
- The Fed is also expected to help monetize debts through unlimited Quantitative Easing (the monthly purchase of assets, which is about ~$120 billion a month as of today) and the potential of Yield Curve Control (targeting a specific level of yield).
The dollar has fallen in anticipation of the above policy measures and has helped create a virtuous circle of expectations and price (higher yields and commodity prices). The reality, however, is not so clear-cut.
Whilst the US has indeed been the most fiscally aggressive nation, that’s not the case on the monetary front:
- The ECB’s balance sheet expansion has caught up and overtaken the expansion of the Fed’s balance sheet. In absolute terms and as a percentage of GDP, the ECB is ahead of the Fed (63% Balance Sheet to GDP for the ECB vs 36% for the Fed).
- Neither the Fed nor the ECB can compare to the Bank of Japan when it comes to the central bank’s balance sheet as a percentage of GDP, as it sits at 131% of GDP.
Additionally, the US fiscal efforts could be hindered by the success of its monetary support. If returns from the equity market are more attractive than the real economy, capital will be diverted from real economic growth drivers (i.e. fuelling GDP growth) into financial markets; a repeat of the impact of monetary policy from 2008 to today.
Price action around Gamestop is representative of how individuals are choosing to allocate their excess cash. The Fed may need to make the equity market weaker to help redirect the funds from fiscal programs towards true economic growth. Simply put, the Fed might need the equity market to lose steam so that fiscal stimulus is allocated to the consumption of goods and services rather than speculation in financial assets. And more than the allocation of the stimulus itself, the Fed might also want the focus of media and market participants to shift back towards the economy, which is much more representative of the reality of the average household.
Lastly, the more successful the US is at generating economic growth relative to its global peers, the more attractive the US markets will be to foreign investors. The difference in yields between the US and German 10-year government bonds has been steadily climbing, and capital always follows higher rates of return.
The US bond market now offers a Japanese investor the same hedged return as the Italian 10-year bond market. Strong US asset prices will encourage foreign inflows, which enhances demand for the US Dollar (part of Brent Johnson’s Dollar Milkshake Theory), driving its price higher and curtailing the enthusiasm around reflation.
The above warrants some contemplation, especially when put in context against how extreme the positioning on the lower US Dollar trade is right now. Speculative positioning in the Euro (as measured by the CFTC) has reached a record level and is extreme even if we adjust for rising levels of open interest. A similar pattern can be seen for all the major constituents of the US Dollar Index (DXY) of which the euro is the largest component. Over the last decade, when euro positions have retraced from the top of the range, the euro has usually fallen by 5% to 10%.
EQUITIES AND RISING YIELDS
Rising yields can undermine risk assets:
- If interest rates go up by 1% broadly, 4% of US GDP ($800 billion) is added towards debt servicing, according to David Rosenberg. This would drive US deficit spending even deeper into negative territory.
- Normalizing rates to pre-GFC levels would lead corporate profits in the US to halve due to higher interest payments, according to Christopher Cole.
The former is interesting but less alarming than one might think, and the latter is unlikely in the medium term. Nonetheless, both show the relevance of yields in the context of government budgets and corporate profits.
Recently, the ratio of the S&P500 ETF (SPY) and the long bond ETF (TLT) has reached the top of its 10-year channel. The rate of change in this ratio is steeper than at any time since 2000 (h/t iv_technicals on Twitter).
The SPY/TLT ratio has previously seen these levels when yields were at the top of the long-term downtrend, but today, the US 10-year yield is nowhere near the top of its channel. This highlights something really interesting to us: the outperformance of equities against bonds in the last months has increased at the steepest rate in the last 20 years.
Whilst the above chart does not imply that equities should stop outperforming, it does highlight that the rate of outperformance has been incredibly high, and any of the risks we mentioned above might challenge this outperformance, at least in the short-term.
We only need to look back at the 20% decline in the S&P at the end of 2018 to see how equities could react to further rises in yields. Today, tech stocks are vulnerable, and last week was a clear example of that.
But if we zoom out for a second, how harmful is a correction in the market? Wouldn’t it, maybe, allow for capital to stop flowing towards risk assets, and move towards real economic drivers, such as debt repayments or consumption of goods and services?
Lower equity markets might allow for fiscal spending to actually deliver the economic growth that we need to justify the current reflation trade. Given the size of the move since November, this can’t happen without some price adjustment, but we could finally have a market that is slightly more aligned with real economic developments.