Since 2010 one of the biggest relative trades has been the outperformance of growth versus value, by an order of 200%-plus. The same can be said of the Nasdaq over the Russell. Same trade, different ETFs.
Portfolio managers have tried to call the turn in value for the past few years and kept getting burned as those stocks just never managed to keep their levels after short-lived bounces. This relative outperformance was exacerbated in 2020 when technology stocks (growth), thanks to the Federal Reserve's $3 trillion in monetary easing and near-zero rates, took off like a rocket and made this relative chart look parabolic.
In light of the enormity of the relative outperformance, the unwind has been and is on everyone's mind. Capturing this turn would make or break one's career. We saw the first hints of it back in November following Joe Biden's win as thoughts emerged that a full Democratic sweep would be massively inflationary and pro-economic growth. Technology got smashed versus energy, financials and industrials. Now after Congress has confirmed a Democratic presidential win, once again the last few days have seen a massive rush into all the reflationary, pro-recovery trades. What is at risk here?
The markets have been gradually nudging higher almost every day since November, without so much as a 3% correction so far. All the liquidity in the system as the Fed buys $120 billion of bonds every month and maintains a very accommodative stance has been very supportive. With the sheer amount of global central bank liquidity pumped over the course of a year -- $22 trillion plus -- there can be no mistake that we will see inflation going forward.
Those who are in the deflation camp need to see just where every single producer and consumer commodity is trading, from soya, corn, lumber, gas and oil to copper, iron ore and steel. The CPI is already nudging above 2% as seen by the breakeven inflation rates. But the pace at which it is happening is what is shocking, and that can be a warning sign.
In just one week of the year, traders have rerated all cyclical and inflation-linked securities by 15% and more. Everyone is chiming inflation and buying anything that rallies with all this free money. Right as it may be, perhaps the extent and speed to which it is being priced in is getting a bit out of sync. Of course, with a quiet Fed that is hell-bent on letting inflation run as hot as it needs to for as long as needed, it means everyone buying anything right now is going to make money regardless of fundamentals.
We know equities are the least sophisticated of all asset classes, pushed and pulled by all major forces, never really having their own mind. By contrast, bonds, credit and foreign exchange are the more sensible ones, taking their time to establish trends and present warning signs, sometimes missed by the more excitable equities. On the back of more fiscal stimulus and now a full Democratic government, U.S. bond yields have moved from 0.5% last year all the way to 1.10%, breaking above the psychological 1% in just a few days. Rising yields are a positive thing if they are accompanied by growth. But if growth is still muted, then this actually hurts consumers as it is more in the stagflation camp.
More importantly, all institutions like gradual moves, not fast, violent ones. We know that about $18 trillion of global debt is negative yielding and this is still one of the most over-owned asset classes. When yields go up fast with inflation rising even faster, this long bond position is at risk of rolling over. When that happens, it can be quite a negative force across the board.
The dollar, which has become the most consensual short position given all the money printing by the Fed, is not really falling anymore despite all this hype about fiscal stimulus. If it even rallies a bit here, it will become a self-fulfilling prophecy as all the risk assets will get hit. The credit market has also ignored the optimism of the equity market this past week. Things just do not add up. Timing is crucial, even if the theme is valid.
We have the Federal Open Market Committee (FOMC) meeting on Jan. 26 and 27. Such a difference a year and $4 trillion of money printing makes. The Fed knows it has egged this massive rush to all assets even though the economy is not seeing any benefits yet. At some point, it will need to decide how to taper or end its bond purchases. Are they even necessary now that we have a vaccine and markets are close to reopening? Either that, or it needs to manage the yield curve.
Higher yields hurt consumer, mortgages and all other parts of the market. It will be interesting to see what Fed Chairman Jerome Powell says and how far he is prepared to let this bubble inflate. We already know it's too big to let it burst, but some sort of orderly exit has got to be on the Fed's mind. All eyes will be on the Fed very soon.
