Since the end of June, there has been a marked shift in not only market sentiment, but also in sector and stock asset allocation and performance. Hedge Funds and institutions are having one of the worst starts to 2H21 as they are all positioned in sectors that are massively underperforming while being underweight stocks that have ripped higher against them.
This may not seem as bad if one were to just look at the S&P 500 broader market index as it has only made new highs reaching 4370 just last week. But underneath the surface, the theme is confounding many portfolio managers. At the start of this year, every sell side analyst and portfolio manager was told to be long value stocks given the economic recovery as countries opened up post their lockdowns, namely being long Energy, Financials, Mining, and Industrial stocks.
This theme was fueled by all the free money being printed by global central banks during the pandemic. We saw U.S. 10 year bond yields rally all the way to 1.80% back in May as the reflation theme was echoing across all trading floors. Today U.S. 10 year bond yields are down to 1.22% and falling, with cyclicals have fallen 15% vs. defensive stocks. Darling Copper is down 12% from its highs, Oil is now down 8% and their respective equities down 15%+.
The so-called reflation trade has completely unwound its year to date gains while everyone is still calling for super cycle commodity prices. Even after the OPEC+ talks were in a stalemate the last few weeks, we saw Goldman Sachs and Citigroup suggest long trades in oil to play the super cycle tightness going forward. The problem with most analysts is that they assume past demand trends hold into the distant future, whereas supply is easier to track. But it is demand that keeps changing within the broader macro construct.
We know that in oil, this was purely a supply driven rally as OPEC+ had deliberately kept about 6 mbpd of oil out of the market as their economies need higher prices to maximize their revenue. China has been deleveraging since end of last year, while DM markets have benefitted from their reopening. But even that is now showing signs of plateauing. This is evident in various global ISM and PMI indicators levelling off here.
But all the central bank largesse, free money printing, is coming to an end as economies have emerged from their post lockdown state. Now they have run out of room to print more when the economy looks like it may need another boost as any opioid addicted victim. This is the never-ending cycle for central banks as a they keep printing through every problem. However, this time around inflation is showing up in places like rent, goods, services, food, and consumer items, and remains stubbornly high leaving them less wiggle room to print more.
Equities are still trading close to highs but the cyclicals vs. defensive ratio has been falling recently suggesting the growth slowdown coming into effect. This is despite everyone long the cyclical long recovery trade. U.S. bond yields are falling, especially in the front as the curve is flattening, suggesting deflation or at least a growth slowdown. Some suggest that the Fed QE buying may be to blame. True as that may be to an extent, there is an underlying them developing here. Commodities are holding up as everyone is long it to play the super cycle, reflation trade even though individual inventory markets are suggesting quite loose balances. But sooner or later commodities will have to start following the theme being priced out by bonds and equities. This is the beauty of cross asset analysis, it just takes time to feed into each asset class.
The Fed reiterated they were not done as there was still a lot of work to be done in the labor market, even though they admitted that inflation has kept up much higher than their expectations. They are not tapering yet but soon they might have to if prices in key parts of the economy do not come down. We know various companies are talking about higher pass through inflation to consumers as well. This coupled with supply side disruptions is causing CPI and PPI to remain stubborn.
So, what will it be, is this a short term deflationary setback or the start of a more ominous trend to emerge? For now, equities and commodities are slowly following bonds as the inflation narrative is cooling off here. History tells us that bonds and rates markets have always been the most sophisticated of the asset classes. Equities are always late to react and analysts even more so.