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  1. Home
  2. / Investing
  3. / Stocks

Is It Inflation or Deflation? You Can't Have Both

Let's pick apart what's going on, and why we should worry about stagflation.
By MALEEHA BENGALI
Aug 05, 2020 | 01:23 PM EDT

When liquidity unwinds, it can be a powerful thing.

Sometimes, positions get so stretched that at any time, when they are unwound, the market needs to put a narrative to suit its mood. This entire year the trade has been growth over value, as technology has been the only sector leading any performance. Most of the stocks in the S&P 500, outside of the big five names, are actually still at the same level, or lower, that they were at in 2018. When one reads "the market is making new all-time highs," it is important to distinguish which index and which names in the index are making the highs. The S&P 500 is dominated by the big five names, given their market cap weighting. But something more sinister has been developing over the past week. The lower dollar narrative.

Central banks are trying to debase their currencies and stoke inflation to work off the debt that has amassed over the past decade. The Fed has increased its balance sheet by $4 trillion over the past few months and now there is talk of an additional $1 trillion to $2 trillion fiscal stimulus bill that is being debated between the Republicans and Democrats. All this is adding pressure on the dollar to the downside. This has caused gold and silver to make new highs for the right reasons, as fiat currency as we know it, is becoming worthless. This narrative is logical as it makes sense.

On the other hand, U.S. 10-year bond yields have been falling for the past month. After staying put at 0.66%, we are now trading closer to 0.51% yesterday. The bond market is suggesting deflation as yields make new lows. This is further causing the gold and silver price to rally, given their relationship with real yields. It is now becoming a self-fulfilling prophecy that, as gold squeezes higher, it is taking dollar even lower. This is boosting risk assets, as lower dollar beneficiaries. The market is using any excuse to bid up risk assets across the board, without asking why and what is happening. We cannot have it both ways. We cannot buy safe haven, gold and silver, on back of deflationary lower yields, but then also bid up risk assets like copper and oil on back of lower dollar. Rather than asking why the dollar is lower, we are chasing the knee-jerk narrative of buying all risk assets. In short, the market has clearly lost its footing for now and there is no theme, just an outright squeeze of all assets.

One needs to ask if we are truly in a deflationary environment, judging by the Institute of Supply Management and new orders and employment data, it seems that the recovery is stalling here after the initial bounce in April and May. There are no signs of a "V"-shape recovery, yet traders are willing to buy up assets in hope of one. There is inflation brewing, but strangely enough it is not showing up in the Fed's measure of inflation, consumer price index basket, but it is showing up in other forms like rent, mortgage costs, food and shelter. The Fed is bent upon letting inflation run above 2%. But it needs to be careful what it wishes for, as once that can is opened, it cannot control it and there is a risk of it spiralling out of control. If inflation is met with wage growth and recovery, then it is a genuine recovery, but as we know, there is lack of wage growth, and economy is nowhere close to being where it was before the Covid outbreak. If the Fed keeps pumping the system with money, without any growth, this can lead to stagflation, which is bearish for risk assets.

For now, we seem to be bidding up everything on the back of the inflation angle. As traders feel a sense of fear of missing out, seeing stocks and assets break out, they are now looking for whatever has lagged and stepping into it to play the next breakout, not looking at the fundamentals. We are placed in a classic situation of the chicken and egg, whereby higher gold and silver prices take the dollar lower and prompt others to buy risk assets on back of a recovery. As people are short, they cover even more, exacerbating the move. It does not make sense and investors need to decide one way or another; either buy gold/silver and sell equities and risk assets, or buy the recovery trade via cyclical assets and sell gold and silver. It seems to be doing both, which means the moves we are seeing today are out of desperation.

That is the power of portfolio unwinds, it is important to question the move and the timing and then step in based on your narrative of the cycle. But am sorry, it is not possible for both you and the house to win.

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At the time of publication, Bengali had no position in the securities mentioned.

TAGS: Currencies | Federal Reserve | Investing | Oil | Stocks | Metals & Mining

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