Marko Kolanovic Says Reflation Trade To Resume – With A Vengeance

When JPMorgan set its year-end 2021 price target for the S&P late last year, it was the highest on the Street.

Fast forward a few months, and the benchmark is just 5% below that year-end target.

Indeed, as I’ve been keen to mention on a number of occasions recently, US equities ran away from analyst targets pretty quickly this year. Prior to the last two sessions, stocks were threatening to completely antiquate Street estimates just four months in (familiar figure below).

There are myriad questions we can ask. What character will the rally take going forward? Will systematic strats increase exposure to match stretched positioning from discretionary investors? Will the rally even continue at all, given stocks have staged one of the largest 12-month surges in a century?

All of those questions (and variants thereof) can be subsumed under one simple query: “What happens next?”

In a new note, out Tuesday, JPMorgan’s Marko Kolanovic ventured a few answers. “Our view is that the reflation and reopening trade will resume, with yields moving higher and rotation from growth, quality and defensives to value and cyclicals,” he said.

Note that the pro-cyclical trade took a breather recently, as the bond selloff stalled, breathing new life into old favorites like secular growth, tech and other bond proxies. It was a kind of “Hey! What happened to my rotation?” moment for a market convinced that an economic renaissance in the US is a forgone conclusion.

Read more: ‘The Main Question’ (And A Lot More)

For Kolanovic, the reopening trade still isn’t priced in, despite the scope of the post-election rotation, which has been impressive on a number of fronts. He sees further gains for assumed beneficiaries, including Energy, Financials, Materials, Industrials, small-caps and high beta stocks. The Russell 2000 has hit a few speed bumps recently, and was down pretty sharply on the week through Tuesday.

Marko addressed the recent “reversal of the reversal,” as I’m fond of characterizing it, calling the drop in bond yields in part a function of technical flows. There’s more on that (e.g., on CTAs’ role) here. He also flagged the increase in COVID cases in India, where the situation is unfortunately deteriorating.

And yet, with the pace of vaccinations still quite robust in the US, and Europe looking to turn the corner, JPMorgan thinks the reflation trade could return soon enough — and with a vengeance. In fact, the staggered sequencing around overcoming the virus could end up being a boon — for market participants anyway.

“We believe that the reopening and reflation trade will resume with a move that will be bigger than we saw early this year,” Kolanovic said Tuesday, adding that over the spring and summer, the COVID-19 recovery “will take place in stages.” The US will be first, then Europe, then EM. That sequencing, Marko suggested, “will prolong the rotation and prevent yields from rising too fast and destabilizing equity multiples.”

That said, the bank’s conviction around the broader market isn’t as strong as their thematic view. The “winners and losers” nature of the macro backdrop means factor volatility is… well, it’s a factor (that’s supposed to be humorous). Specifically, Marko noted that factor volatility catalyzed by yields and the market’s laser-focus on the daily ebb and flow of the reopening narrative, is now “up to ~5 times larger than market volatility.”

In the figure (below, from JPMorgan), Kolanovic illustrates the bank’s take, contingent on bond yields and the evolution of the reopening trend.

The implication is clear enough. Assuming the COVID-19 recovery goes according to plan, “reopening, reflation and inflation themes, and value will likely outperform growth and defensives,” and “significantly” so, Kolanovic said, noting that as yields rise, factor volatility increases relative to market volatility.

The straightforward takeaway is that for those wondering whether the recent pause in the pro-cyclical trade and apparent ebbing of reflation optimism presents an opportunity to reengage with themes, styles and equities expressions expected to benefit from the reopening, the answer, for Kolanovic, is “Yes.”