There's one story that's dominating trading floors today, and that's how far inflationary
pressures can impact bond yields and what effects rising bond yields will have on risk
assets.
Some of the yield sensitive sectors, such as Investment Grade Corporate bonds, utilities
and tech, are now coming under intense pressure as those yields continue to push higher.
The inflation signals continue to build across a number of assets.
Speculative positioning in copper futures is at an all time high, but this hasn't stopped
copper prices from being propelled back towards the highs of the last 20 years.
Crude oil futures have regained pre-pandemic levels despite demand remaining sluggish.
This has helped the energy sector win back some of last year's underperformance vs. the
tech-heavy Nasdaq.
Whilst the steepening yield curve has fueled the outperformance of banks against the same
index in what could be a topping formation that favors more outperformance by the banks.
The drive higher in bond yields has been pushing real yields higher too, which itself has been
one of the main culprits of the recent underperformance of gold.
If we look at the ratio of copper versus gold compared to the US ten-year yield, it suggests
those yields should be headed much higher.
But first, there's some significant resistance to overcome around the 145 to 150 percent
level.
In simple terms, things have been moving pretty quickly on the inflation front.
But just how real are these inflationary pressures?
Is there a danger that inflation is just a mirage of weaker US dollar and extreme positioning
by active managers who've been happy to chase for momentum?
For owners of assets which have negative correlation to yields and inflation, it doesn't matter
whether inflation is real or not, if the market prices for it anyway.
In The Big Conversation, we're going to look at charts which help contextualize this inflationary
backdrop and whether we should be worried that the reflation trade could become a victim
of its own success.
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Investors have been steadily increasing allocations to commodities and short-term government bonds
as hedges against rising inflation.
This is despite the fact that central bankers remain relatively sanguine about the risks
surrounding inflation, which they see as weighted to the downside.
Markets however, are taking a different view, having pushed 5 year inflation expectations
to the 10 year highs.
But why does this matter?
Well, clearly, given the huge levels of both private and public debt, any underlying event
that forces the Fed's hand in terms of raising rates could have major implications for a
still fragile global economy.
The market is starting to bring forward its expectations of rate hikes with the December
2023 Eurodollar futures selling off this year.
Now it's still some way off, but the shift is building momentum and the path to pricing
inflation could involve rotations out of many long-term winning sectors like tech and investment
grade corporate bonds.
If policy makers aggressively confront the inflation genie, it could well abort the economic
recovery and plunge the world back into a global recession.
But getting behind the curve could mean yet more inflationary pressures and risk significant
capital losses for bond market investors, which today also includes the many holders
of bond proxy assets in the equity market.
Today, there is a far greater stock of assets which could follow bond prices lower.
Today's inflationary fears have been stoked by figures such as former Treasury Secretary
Lawrence Summers and former IMF chief economist Olivier Blanchard, both of whom have noted
the current high rate of U.S. personal savings.
The amount that Americans have in their savings spiked for two reasons - the inability to
spend discretionary income due to Covid related shutdowns and the fiscal relief transferred
to households under the CARES Act.
Households, in theory, at least, are chockablock with spendable cash.
But this cash may not be evenly distributed.
We know inequality has increased again, and it may be that the cash is being held as a
buffer against future risks because the eventual reopening of economies will also see an end
to debt holidays and return to settling invoices in full.
But how real are true global inflationary pressures?
Inflation expectations may have picked up across the world, but the pace is not even.
The difference between European and US forward inflation expectations are close to historical
lows.
Europe's increase in expectations have lagged far behind that of the US.
But even in the US, the potential for inflationary pressure is probably overstated if we make
a distinction between actual savings and opportunistic savings, where opportunistic savings could
be used to offset debts elsewhere.
American middle-income households again went into a crisis with high levels of credit card,
student and auto debt.
Although overall household debt to GDP looks to have fallen, it again reflects the uneven
distribution between the haves and the have nots.
It's easy to forget now that the global economy was not in a strong position prior to the
pandemic.
Growth has been patchy and capital has been allocated towards asset prices rather than
to growth.
And if the excessive savings are not going to be used to reduce household debt, then
reversing that process will require two things; a high level of consumer confidence, which
historically has helped to drive up additional debt accumulation and also job and household
income levels that induce lenders to actually lend.
With respect to consumer enthusiasm, the Michigan Consumer Sentiment Index was down again this
month at 76.2 from 102 pre-pandemic.
Household incomes are in an unhealthy state.
If you ignore federal transfers, consumer lenders don't tend to lend to households who
are trying to make ends meet through government subsidies.
Of course, there may well be some inflationary bottlenecks as people normalize their lives
and seek services they've missed out on for a year or more, particularly across the entertainment
industry.
But a Steven Blitz, chief economist at T.S.Lombard, put it recently "to those anticipating big
reopening related surges in prices...perhaps the surge will be more evident in Michelin
starred restaurants than in the local diner."
And are market expectations realistic given the prevailing economic weakness in other
parts of the world, or at least the far lower levels of inflationary enthusiasm being priced
into other regions?
And its most recently published minutes, the ECB policymakers committed to keep a steady
hand on stimulus measures, promising to disregard any short-term jumps in inflation.
The ECB is also paying little heed to the existing inflation data, which showed headline
consumer price inflation hitting an 11 month high of 0.9% in January, up from -0.3% in
December, according to a flash estimate published by Eurostat in early February.
This fastest jump in more than a decade was driven by a combination of one-off factors
rather than a revival of underlying demand.
Because many of the bloc's shops, schools and leisure venues remain closed through this
period.
The reversal of a temporary reduction in German value added tax at the start of this year
played a role, as did higher energy costs and supply chain disruptions that have raised
container shipping prices for retailers and manufacturers.
Thus, inflation is mainly due to bottlenecks.
Sustained European inflation is still well short of the 2% target and sustained is the
key word here.
We saw inflation rebound after the great financial crash, but it was unable to hold onto those
initial highs.
European price pressures have also been buttressed by huge fiscal support packages that have
slowed down the pace of bankruptcies that had initially accelerated in the second quarter
of 2020.
If capital is being used to keep businesses on life support, then it doesn't have a great
deal of future inflationary potential.
The problem is that once there is a return to some form of normality, these support packages
will end.
Repayments will be demanded on many of these loans that have been implemented to prevent
corporate bankruptcies, which in turn could well intensify deflationary pressures in Europe.
In other words, Europe is a breeding ground for deflationary pressure.
And what about China?
As most nations around the world have struggled with new lockdowns and layoffs in the face
of the surging pandemic, the Chinese economy has bounced back after bringing the Coronavirus
mostly under control.
The Chinese economy rebounded 2.3% at the end of last year, the country's National Bureau
of Statistics announced in January.
And obviously there's always a great deal of cynicism around these data points from
China.
But in the short term, it serves a point.
While the recovery remains uneven, factories across China are running on overdrive to fill
overseas orders, and construction sites are busy again, reflecting a boom in exports and
debt fueled infrastructure investments that is expected to drive the economy during the
coming year, including through the Communist Party's 100th anniversary celebrations in
July.
This is one of the reasons why we've seen a surge in commodity prices in the last few
months, with global demand for copper being led by China, where Shanghai inventories are
also at the bottom of their multi-year range.
As far as Chinese growth goes, it's worth noting that much of that growth is being directed
towards reestablishing global supply chains that were disrupted throughout 2020 as a consequence
of Covid-19.
As these supply chains are reconstructed, they will effectively eliminate many of the
bottlenecks that have led to upward pressure on prices.
Therefore, can we actually have global inflation that is predominantly only really being priced
in the US?
China's ongoing state activism means that they will continue to finance CAPEX overcapacity
through their state-owned enterprises, which will generate more deflation in the West.
The economic and political lifeblood of China remains highly dependent on continued investment
to ensure the state remains front and center in the economic sphere by propping up the
SOE's and the state-owned banks.
And that objective imparts a powerful deflationary bias to the global economy.
[00:09:32] The implications for the US is that any wage inflation gains are likely to
be transient at best.
Businesses will lean against wage pressure by cutting back hours or simply refusing to
take on more workers in order to preserve profits, including stock prices and CEO compensation.
All of this suggests that the global inflationary story is still one of bottlenecks, rather
than demand.
China has bought up commodities in order to kick start their supply chains to the rest
of the world.
They will eventually flood the market with goods.
Europe's fiscal support will retain levels of business capacity that should have disappeared
long ago.
Meanwhile, higher yields and extreme positioning across dollar assets reflects dollar inflation
rather than global growth reflation.
The U.S. 10-year yield is approaching a key resistance level at 1.5%.
It doesn't matter if inflation materializes, if risk assets react negatively to its potential.
It would be good for risk assets if yields took a breather here and gave the real global
economy a chance to catch up with the enthusiasm that's currently being shown by those inflationary
assets.
One of the key parts to the reflationary puzzle is the health of the US consumer.
U.S. consumer stocks are now reporting and I spoke to Refinitiv's Jharonne Martis about
the trends that are emerging.
As we've noted, households are sitting on significant savings, but that doesn't mean
they're getting set for a blow-out return to consumption.
[00:10:59] The latest reading on the consumer confidence at Refinitiv tells us that consumers
are becoming significantly more positive as they're seeing that the employment situation
in the country has been improving.
The only skepticism that the consumers have is in terms of the future.
There is some uncertainty there.
And with the pandemic, obviously, they're worried about what might happen.
So as a result we're seeing that savings rate is still significantly high.
We're seeing that consumers are still deleveraging, they're paying off their debt and they're
trying to save money for a rainy day.
Given the upheavals of the last 12 months, there have been some obvious winners and losers.
Those with the most flexible and full-service offerings have faired best.
Omni Channel has been critical in the survival of the retailers during the pandemic.
The retailers with a strong Omni Channel presence have been the biggest winners and are expected
to continue to do so.
In fact, Wal-Mart reported stellar revenue numbers last week and they said that they're
going to be investing significantly in their technology and their Omni Channel presence
because they know that consumers want a fast and convenient way of shopping.
Now, these investments are not cheap by any means, but they are the necessary evil in
order for retailers to stay afloat.
On the other hand, the retailers that are playing catch up are the ones that have been
struggling the most, especially the mall stores and the department stores that have been out
of favor even before the pandemic started.
So we're seeing that the retailers that have done the legwork, Wal-Mart, Target, Home Depot,
are, might get a little bit hit on their stock prices when they report because they're saying
that they are going to be making these investments.
But these investments are paying off, and it's what keeping is keeping these companies
afloat and are allowing them to remain winners during these strange times.
Many of the changes we've seen have been profound and these shifts are going to be permanent
in nature.
Retailers believe that this change is permanently.
Wal-Mart who is the largest retailer in terms of revenue.
They reported last week and they said that they believe that these changes are here to
stay, that they are permanent.
In fact, even in a collaboration that Refinitiv did with Maru/Blue Public Opinion in a survey,
we discover that about 70% of Americans are telling us that even as the vaccine becomes
widely available and the pandemic is over, they do intend to continue to shop online.
For the last quarter alone, fourth-quarter, e-commerce in the United States grew about
32%, and that's expected to continue to grow even further to 43% as per Refinitiv IFR data.
And consumers are also telling us that even when things go back to normal, they intend
to continue practicing social distancing measures and they intend to continue avoiding large
crowds.
Plus the retailers that are on the other side of the world in Asia who have already reopened
significantly, they're telling us that consumers are returning to the stores and mall traffic
is back at the levels seen pre-pandemic, but consumers are still gravitating online to
finalize those purchases, which is telling us that these changes are here to stay permanently.
So the consumer has been remarkably resilient during the pandemic, perhaps no surprise,
given the income support, but they still remain cautious as we heard.
This will be one of the biggest challenges for policymakers.
Papering over the holes in demand is not the same as stimulating new growth.
Consumption patterns will normalize, but it will still take some time before previous
levels are regained.