Nomura’s McElligott On The Comeback Of The Reflation Narrative

Just a few weeks back, it appeared as though the reflation trade and the pro-cyclical impulse across markets might be running out of steam.

If it was, it was due for a breather. After all, things had run pretty far, pretty fast since November, when Joe Biden’s election, Janet Yellen’s Treasury nomination, and vaccine readouts bolstered the re-opening trade.

Late last month, Morgan Stanley said “the reflation rotation may be ready for a much-needed, and deserved, vacation.” It was, on many metrics, extended. Breakevens had overshot on Deutsche Bank’s model, for example, and the figure (below) shows you one manifestation within equities.

Fast forward a few weeks and the narrative is back, even if every cross-asset expression isn’t reflecting it.

This week’s data stateside (e.g., price pressures in manufacturing PMIs and upbeat employment data headed into January payrolls) combined with big, “temporary” surges in inflation across the pond, have resurrected the hype or, if that’s too strong, re-focused the market.

“The market’s attention to ‘reflation’ trades — after seeing a lot of tactical profit-taking over the course of January — has exploded again in recent days,” Nomura’s Charlie McElligott said Thursday. Five-year breakevens are near eight-year wides, cash 5s30s is the steepest since 2015, and heavy high-grade supply is pressuring the long-end.

Charlie reiterated the gist of the narrative as outlined here over the past several sessions.

“This has been driven by the first confirmation of a ‘whites of eyes’ inflation impulse in the US, after the monster ISM Manufacturing Price Index number this week, reflecting stronger demand, supply chain bottlenecks and what had been relative weakness in the dollar,” he said.

But it’s not just the economic data. It’s also the read-through for future economic data of vaccine rollout.

As noted here on Wednesday, virus hospitalizations show a clear downward trend and it’s likely that as vaccinations continue, they’ll keep falling. Hopefully, that will translate to lower fatalities and reopening across the services sector.

So, with the market’s focus now back on the reflation narrative that drove the rally from November through January, it’s possible to argue (and many are) that it’s all got legs again, especially in the near-term as last week’s unfortunate “rinse” (to employ an amusing euphemism) fades into the rearview.

“There has been an obvious ‘everything up’ trade across themes and factors this week off the peak of last week’s gross-down/net-down freakout lows,” McElligott went on to remark Thursday, noting that once “everybody shed exposure, the point of pain then became a market move higher, which only accelerated.”

Essentially, this week witnessed an across-the-board sigh of relief once it became apparent that an 800,000% (roughly) rally in shares of a hole-in-the-wall, left-for-dead Xbox game retailer wasn’t likely to sink the US financial system.

And you can go ahead and laugh. Because it’s funny.

We’ve come a long way in a dozen years. I’m “old” enough to remember when “systemic” meant Lehman. Now, we’re using “systemic” in the same sentence as “GameStop.”

In any event, thanks to realized vols calming down, the vol control “background” bid should help support the market, McElligott added on Thursday. “Further calm would see additional rebalancing into Equities from vol control,” he said.