Since the last quarter of 2020, all we have been hearing about from any sell-side investment bank has been to be long the reflation trade: a play on the reopening of the global economies after lockdowns by being positioned in stocks and sectors that are geared to that phase of the post-COVID recovery.
These tend to be sectors like early stage cyclicals, economically sensitive stocks geared to the recovery like oils, miners and financials. Prior to the fourth quarter of 2020, rates kept moving lower with the Fed doing more and more quantitative easing. This encouraged people to invest in growth sectors like technology as they benefited the most with lower rates. Once a vaccine was found, the generational long opportunity to play that underperformance catch-up trade was picked up by all as value stocks took off like a lightning bolt at the cost of growth stocks. Throughout the first half of the year, until early May, that theme played out extremely well.
But something changed over the past two months: Value gave away almost all of its year-to-date gains vs. technology as the latter rallied significantly at a time when everyone was underweight.
So, what really changed to cause this "deflationary" shift in the market. U.S. 10-year bond yields, after hitting a 1.80% yield, are now trading down to 1.35%. U.S. bonds should not go up when inflation is picking up. But one needs to be careful if looking just at the yields alone. Given Fed's constant QE and monetization of debt, the yields represented by the bond market may not necessarily provide any insight as the market is a bit manipulated now. In addition, there are genuine slowdown concerns since global PMI peaked in May, as China's slowdown is impacting the markets and its relevant commodity prices. This slowdown is real, as China's credit impulse has been slowing down since December 2020. Most hedge funds were not positioned for this slowdown as they were busy focusing on all the money central banks were pumping into the system with talks of more fiscal spending to come. Yet in June, this spread-unwind caused a great deal of pain as they were not positioned to capture the upside move in technology stocks.
Central bankers continuously tell us that this inflation overshoot is "transitory" due to base effects. The truth is that they really do not know. This is an experiment and now it is too late to do anything else. They would like to taper or at least "think about thinking about tapering" but the flashbacks of December of 2018 seem too raw in their minds to consider that. At some point, they will need to wean the system off its free money addiction, but they are hoping that there is enough momentum in the US economy to be able to withstand the withdrawal of liquidity that it has so gotten used to. The June CPI release printed 5.4% year-over-year vs. expected 4.9% and Core CPI came in at 4.5% year-over-year vs. 4% expected. It may be naive to just blame supply chain disruptions and used car prices for all of the increase, but food and energy prices are picking up as well along with rent/shelter inflation, albeit small for now. The inflation is in the system and there are some parts that will be stickier than others, but to dismiss it just as base effects would be rather naive.
The debate between inflation and deflation continues for now. Just because modern monetary theory never generated inflation in the past, it does not mean it cannot now. After all we never had $4 trillion of excess liquidity thrown at the system in such a short span of time either on both a monetary and fiscal basis. Time shall tell who wins, but perhaps we need to consider that in fact, it may be the "deflationary" theme in the market that could be transitory.