After the November elections through the start of the year, we were filled with endless reports to be long the recovery/reflation trade. Basically, to be long underperforming "value" sectors looking past the near-term weakness into 2H21 when the world would slowly normalize back to pre-Covid levels post vaccine distribution. It was easy to make that call when every politician is touting numbers as high as $2 trillion or $3 trillion to give to the people (of course more lining up the pockets and their subsidiaries than going to the economy), but a fiscal boost no doubt. A recovery was inevitable. It is also easy to make that call when looking at the past 10 years, these stocks have been such laggards. With new vaccine rollouts, and sell side upgrading all their commodity price forecasts calling for an inflationary recovery, investors have priced in all the good news of 2021 in a matter of weeks. What could possibly go wrong?
It is always important to assess how much an economic cycle is being priced in, or what is known in the market. The problem with this recovery trade is everyone assumes that once the central banks keep pumping the system with enough money, economic growth will eventually happen. That is what Fed officials are hopeful for. The only worry is we are certainly seeing signs of inflation as every single commodity has been shooting higher since last year from Soya, Lumber, Corn, Copper, Steel, and Iron Ore, etc. Given the Philly Fed numbers we are certainly seeing some of it passed onto consumers as well. But there is no wage inflation, so the consumer is not happy. Whether or not the Fed likes to admit it, CPI is alive and well above 2%, just their measure ex Food and Energy shows a lower number. They need to let inflation run hot before they can pull the rug from underneath the markets. It is their only option. But what about GDP growth?
Investors rushed to be long the growth/recovery stocks as they assumed we would get the growth as well as inflation. But the truth of the matter is that the global economy is far from pre-Covid levels. Vaccine roll outs will take time to reach 70% immunity level. Not to mention EU, UK and now the U.S. are going into stricter lockdowns, despite giving more doses to their population. This is before businesses are able to come back and hire again. The next quarter and possibly Q2 could still be tricky. Are investors really willing to look past the short-term blip? Are they that certain we get the eventual recovery? Investors are always eager chasing stocks 20%+ higher from here, hand over fist, as they did in first week of January. As stocks fall 20%+, they give up, and the narrative is lost.
The market is one big asset allocation trade based around the dollar. At the start of the year as U.S. bond yields rose towards 1.15% and higher, everyone cheered the recovery. We all know the Fed will not let rates rise too much as that questions their recovery. They have yet to officially announced yield curve control. As demand is looking softer now into Q1, these yields moved back down and the narrative is shifting towards stagflation. These two different views have very different asset allocation choices. One is to be long equities, cyclical assets, "value" and short dollar and growth stocks (Technology). The other is to be short cyclical assets, commodities, long the dollar and long Technology (growth). Just one view on U.S. bond yields and the dollar, and your relative long/short portfolio changes. So, which one is it?
The market is tired of hearing about fiscal stimulus but not seeing any, seems like $1 trillion will not be able to get through. One thing is for sure, if that is the number the market will not be happy as the economy needs a heck of a lot more. Asset prices have already priced in much more. The Fed is tired of promoting monetary policy as they need their government to push through the fiscal policy.
On Wednesday we have the FOMC, and then let's see what Yellen has in store for the markets. Going back historically, she really has always been a dove but perhaps the real problem of wealth inequality is embarrassing most Fed officials. Could they possibly change their policy to get the money to reach the people who need it most? We shall see what the future holds for the dollar as that is and always will be the key deciding factor for asset allocation and sector allocation too. It is all one big macro trade, just leveraged differently in different asset classes.
