As the year has started in earnest, it seems the topic of inflation and the recovery trade is on every sell side analyst's minds as each publish notes upgrading their forecasts higher for oil, copper, and equity markets calling for 5% GDP growth in Q1'21 (Goldman). Once a vaccine was found, everyone has now assumed a full rollout and the world going back to normal in a matter of months. All these bullish forecasts hinge on some pretty strong assumptions, most importantly how soon will the entire world get vaccinated and businesses shut down return back to work? It will not be like a magic wand. The path is towards better economic growth but it will be far from a straight line. What was meant to be priced in over the course of the year, has been in fact priced in just a matter of few months as seen by the Russell 2000 Index, up by 30% since November, and way beyond their 2020 levels. As this reflation trade was priced in, the winners of the last year, namely Technology, have been sold down aggressively by portfolios as they rush to chase "value" cyclical sectors.
Companies are now reporting their Q4'20 numbers and year over year growth is estimated to be down 11%. This should come as no surprise and is a bit backward looking. However, information Technology is one of the only sectors to show a positive 1% year over year EPS growth. In short, Technology is not dead. Most top down macro specialists seem to have closed or unwound their longs chasing all the "cheap" oversold cyclicals, positioning themselves for the new recovery basket, but there could still be some chips left on the table. From a macro perspective, it is understandable that as nominal yields move higher, the lure for Technology fades from a sector allocation perspective. But from a fundamental bottoms-up perspective, the cash and earnings growth story is far from over for this sector. Technology seems a bit unloved, but if some love comes back to the space following Q4 numbers, we can see some violent rotation out of these value sectors as well.
It all hinges on the dollar and U.S. bond yields. What was once a topic of contention at various portfolio manager meetings is no longer disputed. Inflation is alive and here to stay. One just needs to look at the price of wheat, soya, corn, oil and every other Commodity price out there, to know exactly how much there is. The Fed conveniently uses CPI ex Food and Energy to benchmark their inflation, which means they are willing to let things run hot before even "thinking about thinking about raising rates". The Fed cannot afford to pull the plug on the accommodative monetary policy and lower rates path, lest they break the market altogether. Their hopes are that U.S. government will get its act together and launch a fiscal stimulus program which is the only thing that can boost the economy, other than just asset prices. The real dilemma is reaching wage inflation given inflation is popping up in all the "wrong" places.
U.S. bond yields have been rising since last year, whether they are allowed to keep rising will depend on whether the Fed embarks on yield curve control or let nature take its course. But one thing is for certain, if the yields move up too soon, the markets will not be able to handle it well. It is not the actual yield as much as how fast that yield moves up. If higher yields are met by higher GDP growth, then it is very positive. But if it is only met with pure inflation, and slowing growth, that is very bearish for equities.
The dollar is one of the most over shorted currencies. It is a one-way bet at the moment. If it rises from here, it can have some serious negative implications for emerging markets and commodities and risk assets, which everyone seems to be long of at the moment. The path may be lower in the medium term, but what if there can be a nasty squeeze in the near term? There seems to be no margin of error priced in.
China's coronavirus lockdown has expanded to 29 million. No one knows why or how but this can only mean a delayed recovery or lower mobility, travel and eventually oil demand. The oil price has only held up as the Saudis took the decision to cut 1mln bpd in February and March, but the longer oil prices stay above $50/bbl. U.S. drilling rigs are rising. More, not less, oil is going to hit the market.
It is easy to get caught up in the inflation trade, but it is also important to know how best to play that. The answer may not be so simple as equities could be a tricky place to be. Given the growth of cryptocurrencies, we have become demanding as traders as nothing less than 100%+ in a fortnight seems to warrant capital allocation these days it seems. But boring as they may sound relatively, the pure inflation hedges are still gold and silver.
