When Covid fear first gripped the markets and the economy, we saw a swift movement of capital in a flight to quality.
This was reasonable to expect and manifested with a closing low on the 10-year Treasury of 0.51% on August 4th, 2020. As of this writing (on April 20th, 2021), the 10-year Treasury has recovered to 1.60%.
The other side of the coin with respect to reflation, is the movement of the Consumer Price Index (CPI). Looking at the year over year (YoY) change series, CPI bottomed in May 2020, recording a YoY change of just 0.1%, a far cry from Fed Chairman Powell’s desired 2.0% inflation target. The most recent release of the CPI was on April 13, 2021, and it reflected YoY inflation of 2.6%.
It has been widely anticipated that the inflation statistics for the next three months will be comparisons to the depths of the Covid Recession we saw last year, and the real level of inflation will be measured once we are later in 2021 and comparing year over year statistics with the late 2020 economy.
An article and discussion for another day, was the rapidity of the downdraft and the equally fast momentum as the economy and capital markets recovered.
“The reality is that the “reflation trade” cannot be taken in a vacuum because
so much has changed in the last six months.”
This backdrop is on the minds of many investors as we begin to ponder the reflation trade.
The reality is that the “reflation trade” cannot be taken in a vacuum because so much has changed in the last six months. Some notable differences are the major move forward with vaccinations and the change in US leadership.
There are still significant concerns about the efficacy of the available vaccines to the various Covid mutations, but the administration of more vaccines has led to continual progress.
As we have progress on the health care side, it is reasonable to expect that the reopening of the economy will lead to significant growth.
We believe that economic growth can be above trend for the second half of 2021 and likely through the first half of 2022.
Our reason for this belief is that the economy was healthy leading up to Covid. In general, we had low interest rates, low inflation, low unemployment, strong consumer and business optimism and we were seeing relatively strong business investment.
“It is reasonable to expect that the reopening of the economy
will lead to significant growth.”
From a broad economic standpoint, the labour market was a bright star because not only were we seeing strong economic growth, but wages were growing fastest at the lower levels on wage ladder, meaning we were seeing broad participation in wage gains across the socio-economic spectrum.
To be sure, all was not perfect in the economy and the capital markets. We were certainly starting to see stretched valuations in the equity markets which had some pundits calling for a correction.
We were watching to see how first quarter 2020 earnings shaped up to evaluate our view of equities. And then Covid came.
On the employment side, while unemployment was low leading up to the onset of Covid, the Labor Participation rate was 63.4% in January 2020 and fell to 60.2% by the end of April. As of the last release in March 2021, the index improved to 61.5%. The concern is that there is still slack in the labour market.
For further context, the Labor Participation index began rising in the mid 1970’s with the growth of dual income families and peaked at 67.3% in January 2000. With the beginning of Baby Boomer retirements, market participants started to analyse what this meant for labour participation.
“The concern is that there is still slack in the labour market.”
In the current market situation, we are about 2% below the Labor Participation rate that was reached just prior to Covid. The unemployment rate stood at 6% at the end of March 2021, so if everyone immediately came back to the employment market, we would see unemployment most certainly fall.
The growth of the money supply, namely M2, is another significant issue being focused on by market participants. The basic view is that there is so much stimulus floating around in the economy, as evidenced by the strong rise in M2, that inflation must be imminent.
The various kinks in the supply chain are also contributing to price increases, leading many to believe that we may be at the starting point of an inflationary cycle.
Further, strong gains in commodity prices from lumber to oil also have consumers and economists looking at a certain upward move in relative prices.
The question we now need to really focus on with this accelerating economic recovery and the most massive fiscal stimulus package, outside of war time, and the Fed’s commitment to easy policy until we see sustained inflation is: ‘Do we see the opportunity for the reflation trade?’
“The growth of the money supply is another significant issue
being focused on by market participants.”
First, as mentioned above, we have slack in the labour market and that could certainly put a lid on inflation. The amount of money still sloshing around in the bond market may put a limit on how high rates can rise just due to technical factors of so much cash searching for a home in the bond market.
One head fake we all need to avoid is the comparisons we will be seeing over the next few months. The year over year comparisons to March, April and May 2020 may show that we have wildly accelerating inflation.
However, it will be the comparisons to the months in the fall that will show whether inflation has taken root or if we saw some transitory whiffs of inflation.
We believe the reflation trade can only truly occur when the slack in the labour market has been absorbed, when The Fed normalizes monetary policy and when the economy is truly open.
I am not a believer in Modern Monetary Theory because I do believe debts and deficits matter and at some point, we will have to pay our bills. Inflation could be a help in this arena because we will be paying current bills with inflated dollars, however, we are still more than a bit away from this.
“I am not a believer in Modern Monetary Theory because I do
believe debts and deficits matter.”
We are in the camp that inflation will certainly be higher than we saw in the early Covid economy. But for inflation to take root and for investors to seek participation in a reflation trade we will need to see a few key elements become more present in the marketplace.
As mentioned earlier, the reflation trade needs to be fostered by a general belief that inflation is rising, The Fed removing stimulus and a continued improvement in both jobs and wages. We certainly could have an exogenous shock, such as an oil spike, that could also contribute to inflation.
We think that Fed will remain true to their word and we will see the beginning of asset purchase tapering in the first part of 2022, with interest rate hikes not likely until late in 2023, at the earliest.
As this remains a highly fluid situation, with as much focused on the virus and its’ variants as the economy, we all must remain flexible in our views in approach.
Ultimately, however, we need inflation to see the reflation trade and we do not believe we are there - yet.
