Stars May Be Out Of Alignment For Market’s Favorite Trade

Hopefully, you don’t find yourself in the unenviable position of being forced to say, definitively, whether the reflation trade has run its course in the near-term.

In some sense, anyone who’s engaged, daily, is compelled to make such judgements. Right now, all macro trades are synonymous with expressing a view on whether there’s gas left in the tank for reflation. Critically, this isn’t as simple as taking a view on whether inflation is “transitory” or not. (And that’s not exactly “simple” either.)

Whether inflation is transitory can be a purely academic debate. Reflation (as distinct from inflation) is a narrative — a story about the evolution of the global economy post-pandemic, and what it means thematically. The two obviously overlap. Traders parsed May’s CPI report to determine the contribution from “transitory” elements, and then quickly made predictions about the likely ebb and flow of reflation trades, for example.

“Strength on a MoM basis was once again led by travel-related prices, most notably used vehicles, car rental rates, new vehicles and airfares, although rents picked up as well,” TD’s Jim O’Sullivan wrote. “The strength can probably be viewed as ‘transitory’ to a large extent, due to post-COVID reopening as well as fallout from the semiconductor shortage.”

That assessment (not O’Sullivan’s specifically, but a similar take shared by almost everyone) prompted traders to question the durability of some reflation trades.

One issue is that while the stars may have aligned figuratively for a fleeting, history-making bump in inflation, they may now be out of alignment in a literal sense. In simple terms: The sequencing is off. More specifically, imbalances in the labor market mean the pace of “slack” absorption is slower than expected, leaving some to wonder if price pressures will have mostly abated by the time the jobs market tightens.

Although some states are beginning to phase out “extra” unemployment benefits, it’ll be months before they expire for everyone. It’ll be another couple of months after that before the jobless are compelled to take what’s on offer from employers. And there’s quite a bit of ground to make up (figure below).

If that process takes too long, the resultant wage pressure could be offset (in the inflation context) by the resolution of supply chain bottlenecks and base effects dropping out of the comps.

Citing client conversations, Nomura’s Charlie McElligott said “a multitude” of traders and investors are “making the case [that] by the time we do begin to see ‘labor tightening,’ [it] will be offset by a fading impulse from the ‘reopening / pent-up demand’ phenomenon, a (disinflationary) push from retailers to discount into said fading demand, price inputs like used vehicles — which have done a lot of the core CPI heavy lifting — increasingly moderat[ing], all as the infamous inflation base effect begin[s] to cut the other way.”

On top of that, it’s far from clear that the wage inflation story is playing out like you’d be inclined to believe if you simply scanned the headlines. “Despite seeing higher prices and having higher inflation expectations, consumers are not using credit cards to ‘buy in advance’ and they will not until they believe wages are going to move higher as well,” TS Lombard said last week.

But what about media reports which suggest employers are increasingly prone to hiking wages and offering a hodgepodge of financial incentives (one-off or otherwise) to entice workers? Well, in the same cited note, Steven Blitz wrote that while we’ve “all read recent anecdotes about wages popping in certain industries for certain positions,” it might be more accurate to “think of these increases no differently than sharp increases for commodities in short supply, such as lumber.”

For Blitz, “this is not the broader wage story — real average hourly earnings fell 0.2% MoM and are down 1.3% YTD.” That’s not to say he doesn’t see inflation picking up. An inflationary process will gain traction next year, he suggested. The key point, for now, is that companies will raise prices but will be hesitant to hike wages. It’s hard to know, Blitz said, “whether this is a bit of gamesmanship between the price needed to fill positions and waiting out liberal unemployment benefits,” but in the here and now, management will raise prices to offset margin pressure from higher input costs. Companies, he went on to remark, “have proven reluctant to translate these price expectations into a generally higher wage structure.”

That’s not lost on consumers who, when they’re not consuming, are working for wages. Unless and until they believe wages are likely to move sustainably higher, they’ll probably be reluctant to leverage their personal (i.e., household) balance sheets to bring forward spending. The implication is that once the “excess” savings from the pandemic run dry, consumption could falter, especially if prices are higher for goods and services.

This is a lot to process, hence rampant confusion and conflicting opinions.

Coming full circle, what if you absolutely had to make a prediction?

“Gun to my head, I’d say that without a tighter labor market to stoke the flames again, ‘reflation’ is out of gas,” McElligott said, noting that the reflation impulse will likely keep fading as we pivot into a “‘Goldilocks 2.0’ economic backdrop” that will make it difficult for the long-end to sustain a selloff and keep a lid on real yields.