For markets, some trepidation crept in as the curtain closed on Inauguration Week in the US.
After what might fairly be described as a “melt-up” (while acknowledging that’s a totally made-up term with no universally agreed upon definition), equities have seemingly “paused.”
Friday’s headlines were rife with disconcerting virus news, from a targeted lockdown in Hong Kong to a dismal spate of data out the UK, where COVID tightened its grip late last year, courtesy of a more transmissible variant.
“Things have turned a bit more defensive in the speculative proxies and risk-premia space in recent days,” Nomura’s Charlie McElligott said, in a Friday note. He cited Bitcoin’s pullback, a stumble in a handful of retail favorites (visual below), and the tentative resumption of outperformance in legacy “safe” spaces versus reflation risk-on trades.
Although it’s far too early to suggest the reflation trade is “dead” or that this latest iteration of the pro-cyclical rotation is poised to suffer the same fate as so many of its predecessors, some are sounding a cautious tone.
“It’s not even the end of January 2021 and yet the great global meme for the year –‘The Reflation Trade’– might be coming into question already,” Rabobank’s Michael Every wrote Friday. “That’s right: the market may have binge-watched the whole thing in just three weeks,” he went on to say, adding that,
Of course, the “Reflation Trade” was never related to underlying economic fundamentals. These have been lowflationary/deflationary for decades. Yes, we have official recognition that we need more fiscal policy. Hurrah. But most of that spending is in the rear-view mirror already; and it’s merely putting the same, and often less, back into the economy than is taken out by state-imposed virus restrictions. In balance-sheet terms, if the private sector net saves an extra 3% of GDP due to a drop of confidence or being told to stay at home, and the government spends an extra 3% of GDP, that isn’t reflationary at all.
If that sounds familiar, it’s because it’s intuitive and also because I’ve made similar points in these pages on too many occasions to count. I’ll have more on it later.
For our purposes here, the point is simply that this trade has run pretty far, pretty fast on almost every conceivable manifestation, whether you want to look at small-caps in equities or rates or [fill in the blank].
Earlier this month, Deutsche Bank quants suggested that breakevens may have overshot. “Although we concur with the general thesis behind the reflation trade assuming the new administration can deliver persistent fiscal support, the slow-moving economic drivers have yet to move in the direction that would substantiate this view, which calls for caution on breakeven potentially running too hot,” the bank’s Jiefu Luo and Jose Gonzalez wrote. On their model, BKEs were one-standard deviation wide.
Early Friday, Nomura’s McElligott noted “further de-risking from reflation trade exuberance.”
Obviously, ongoing news flow which suggests Republicans will push back on Joe Biden’s stimulus package will serve to dampen the mood.
“It’s hard for me to see when we just passed $900 billion of assistance why we would have a package that big,” Susan Collins said Thursday, of Biden’s $1.9 trillion plan. “I’m not seeing it right now but I’m happy to listen,” she added.
Perhaps Collins needs to “listen” to the nearly 10 million people who had a job this time last year but who don’t now. I’m sure they’ll be happy to tell her their stories.
In any case, when it comes to the reflation trade, I’m reminded of the following excerpt from a November piece by NotesFromDisgraceland:
There is an archetypal scene from a Looney Tunes cartoon that plays upon the contingency of the existing rules and which relies for its comical effect precisely on the confusion of the two levels of interpretation of the laws of physics. In each episode, the cunning, insidious and constantly hungry Coyote repeatedly attempts to catch and subsequently eat the Road Runner, a fast-running ground bird, but is never successful. In his pursuit he always goes one step too far — just when he thinks he has caught up with the bird, Wile E. Coyote finds himself floating in the air above the precipice, and he falls only after he looks down and becomes aware that he has no support beneath his feet, as if he has momentarily forgotten the laws of gravity his body must obey, and has to be reminded of them.