Albert Edwards: The Reflation Trade May Be About To Unwind

Point, counterpoint, I suppose.

The reflation narrative is making a comeback after taking a brief hiatus, but some think that narrative may be detached from reality.

One of those people is SocGen’s Albert Edwards who, on Thursday, expounded a bit on the topic. “Much of the equity and commodity world has raced higher on the back of the reflation trade,” he said. “The unusually deep inversion of the breakeven curve tells us the trade may have gone too far and is about to unwind.”

He cited a number of additional data points and visuals in the course of making the case, including a disconnect between PMIs and consumer confidence. The visual (below) is a kind of 30,000-foot view of the reflation zeitgeist.

As far as factors that could spoil the party, Edwards mentions a decelerating Chinese credit impulse.

That’s important. As most macro observers are acutely aware, China’s credit cycle at times feels disconcertingly synonymous with the global economic cycle. That’s a kind of chicken-egg dilemma, and sometimes folks take it a bit too far, but there’s a lot of truth in it.

“China has been one of the few economic bright spots in a COVID-hit world,” Edwards wrote, adding that “historically, a downturn in China’s credit impulse is bad for cyclicals and commodities.”

Meanwhile, the zombies are still roaming. Indeed, they’ve proliferated in a world where earnings have collapsed but access to capital markets has remained wide open thanks to central bank backstops. The figure (below) uses a Bloomberg proxy, but you can obviously show the same dynamic any number of ways.

Even as bankruptcies in the US surged to the highest in more than a decade last year, policy support prevented the kind of credit apocalypse that might have otherwise unfolded. In addition, the hunt for yield engendered by the same monetary accommodation drove investors out the risk curve and down the quality ladder, thereby forestalling “creative destruction.”

I’d remind you that “creative destruction” is a fun euphemism for this: “The kind of chaos nobody living in an advanced economy is actually prepared for, no matter what they say on Twitter.” I vastly prefer the phrase: “Preventing the purging of misallocated capital.”

Do yourself a favor and use that in place of “creative destruction.” You can always make a plausible argument for the purging of misallocated capital, assuming you can prove it’s “misallocated.” “Creative destruction” takes you into the philosophical realm, where you probably don’t want to go.

“Transfers to firms, together with credit guarantees and funding-for-lending programs, have prevented bankruptcies that might otherwise have occurred but also [kept] some unviable firms afloat, which could put a drag on overall productivity in the future,” the IMF said, in the Fund’s latest World Economic Outlook, which revealed that a staff analysis of more than a dozen advanced economies from 1990 through 2020 showed bankruptcies falling during the pandemic recession. I used the chart (below) last month, but I’ll present it again here.

Obviously, that’s anomalous. Whether it’s desirable or not is in some sense a normative question.

The IMF wrote that “if policy support is withdrawn before the recovery takes firm root, bankruptcies of viable but illiquid firms could mount, leading to further employment and income losses.” Edwards on Thursday pointed to the deflationary implications, calling it “why we are currently overrun with these deflation-inducing and productivity-stifling ‘Zombie’ companies.” The figure (below) is adapted from a Matt King slide deck, although it’s been so long, I couldn’t put a date on it.

Coming full circle, professional trader Kevin Muir drew a distinction between “reflation” and “inflation” in his latest note to subscribers on Wednesday evening.

“‘Reflation’ is not the same thing as ‘inflation,'” he said, adding that,

‘Reflation’ is easy to rein in. All you need is to withdraw the stimulus. The natural state is for prices to drop without external forces being applied. Inflation, not so easy. Once it starts, it’s harder to stop. We haven’t had traditional inflation in a long time. I know there are lots of prices that have risen quite a lot over the past couple of decades, so I’m not arguing the current inflation rates represent true levels of price rises. The hedonic adjustments definitely have a way of keeping reported inflation much lower than it “feels” in real life. However, inflation represents an across-the-board rising of prices. That’s a lot different than economically-sensitive commodities responding to “reflationary” stimulus.

Kevin noted that from where he’s sitting, it doesn’t appear that markets are actually pricing in “inflation.” Rather, they’re just riding the reflationary narrative for a trade.

“The two-year inflation swap has rebounded from 0.00% to 2.25%, but look at the 30-year swap,” he said. “It’s sitting just slightly above the two-year at 2.35%.”

Muir contends that folks simply don’t believe that real inflation is likely to be “a thing” (so to speak) anytime soon.

“If the market was concerned about long-term inflation, this curve would be steep,” he said. “Instead, it’s flat.”