While some market participants believe the reflation trade may have largely run its course, JPMorgan’s house view remains favorable for cyclicals. Inflation surprises, the bank said Monday, could “persist.”
“Our outlook remains positive for risky asset classes,” analysts led by Marko Kolanovic wrote. Stocks and commodities will have the highest returns, the bank suggested, and bond yields are likely to trek higher.
On several occasions over the past few months, Kolanovic reiterated his view that the reflation trade likely isn’t done. Last month, for example, he cautioned on widespread vulnerability to higher inflation outcomes.
“For over a decade, only deflationary (long duration) trades were working, and many of today’s investment managers have never experienced a rise in yields, commodities, value stocks, or inflation in any meaningful way,” he said, adding that “a significant shift of allocations towards growth, ESG and low volatility styles over the past decade (all of which have negative correlation to inflation) left most portfolios vulnerable to a potential inflation shock.”
So far in 2021, commodities are the clear winner (figure below), with bonds the loser and IG credit lagging as well (think duration risk).
I’ve spilled gallons of digital ink lately documenting the sideways, narcoleptic drift in equities. For JPMorgan and Kolanovic, “the next leg higher is likely upon us.”
“Despite peaking in some activity indicators, the market is likely to get comfortable that growth will remain significantly above trend in H2, supported by both consumer and capex,” Kolanovic and co. wrote Monday, on the way to delivering a take on inflation that’s perhaps a bit less benign than the most sanguine forecasts, albeit constructive for stocks.
“Risks are skewed for recent inflation surprises to be sustained into the second half of the year,” the bank said, a view that favors equities.
JPMorgan doesn’t skirt the issue when it comes to the prospect that upside surprises on the inflation front might entail higher real yields.
Note that the conjuncture shown in the figure (below) is widely credited with creating a fertile environment for equities, as higher breakevens bolstered the reflation narrative while (deeply) negative reals helped protect against any kind of dramatic de-rating, despite nosebleed multiples.
I’d be remiss not to flag (again) the possibility that what you’re seeing in breakevens may be a distorted.
There’s no shortage of cautious commentary about what might befall equities in the event further rate rise is driven by higher real yields. For JPMorgan, dodging any associated tumult could mean simply avoiding the temptation to dive back into duration-sensitive corners of the market, favoring value instead.
“As the Fed is likely to take steps towards an eventual taper in coming meetings, and inflation markets are already pricing inflation outturns above economists’ forecasts for 2021 and 2022, further upside in nominal yields is more likely to come from higher real rates,” the bank said. “This suggests that it is premature to come back to Tech, but Value and value-oriented sectors should continue to outperform.”
The bottom line, from Kolanovic, is that a “pro-risk view” is justified by “the ongoing recovery, accommodative monetary stance from global central banks, and still below-average positioning in risky asset classes such as equities and commodities.”
That view, as stated anyway, is difficult to refute. I’m notoriously prone to making things more complicated than they need to be, so it’s probably a relief for readers when I go for brevity, this time courtesy of Marko’s macro summary.
As for how long such an environment might persist, JPMorgan said this particular thesis is probably good “at least” for the summer, and quite possibly “well into” next year.