Reflation Trade Is Back

A much softer than expected US January jobs report didn’t prevent US equities from closing higher at the end of last week as the reflation trade kicked back in.  One of the biggest driving forces for markets was the growing prospects that much of President Biden’s $1.9 trillion fiscal stimulus plan will be passed, albeit via a process of reconciliation, which allows Democrats to circumvent the need to gain the support of at least 10 republicans. This contrasts with prior expectations that the final stimulus was going to be less than $1 trillion. 

Pushing stimulus through this way highlights Biden’s urgency to inject more spending into the economy but could come at the cost of hurting bipartisan policy efforts. The impact of expectations of increased fiscal stimulus is particularly apparent in the US rates market, with US Treasuries selling off and bear steepening of the curve.  Although higher US Treasury yields failed to give support to the US dollar (USD) there is still scope for a short covering rally, which could still help give the USD relief.     

At the beginning of the year the US jobs market took a hit from renewed lockdowns and surge in COVID cases; US January non-farm payrolls increased 49k, and December was revised to -227k from -140k while more positively the unemployment rate fell to 6.3% from 6.7% though this was flattered by a drop in the participation rate as less people were looking for work.  According to the payrolls report there are still 9.9 million more unemployed compared to pre-COVID levels.  As such, the weak jobs data added more support to Biden’s fiscal stimulus proposals.   

This week focus will likely turn more to President Trump’s impeachment trial in the Senate than economic data.  Key data/events this week include China’s credit and monetary aggregates (9-15 Feb), central bank decisions in Sweden (Wed), Philippines, Mexico (Thu) and Russia (Fri).  Among these the consensus is for only Mexico to cut its policy rate. Also in focus are inflation readings in China (Wed), US (Wed) and India (Fri).  UK GDP (Fri) and US Michigan sentiment (Fri) will also garner attention. 

The return of the reflation trade, rally in risk assets and decline in cross-asset volatility bodes well for emerging markets (EM) assets.  However, there are definitely various cross currents impacting asset markets at present especially with US Treasury yields rising, which could potentially support the USD and pressure EM local bond rates markets.  EM assets were clearly favoured towards the end of last year, and while the positive story has not dissipated, EM assets may take a pause for breath before pushing higher again.  

In Asia, the Chinese-new-year holidays this week may dampen activity while China’s PBoC also appears to be limiting liquidity injections around the holidays, which could limit some of the gains in Chinese and impact China linked assets.  Chinese authorities have re-focussed attention on preventing an excessive build-up of leverage and credit metrics have peaked as a result.  As such, they may be less keen to inject a lot of liquidity into markets at present. 

The Week Ahead

This week the difficulty of trying to pass President Biden’s $1.8tn stimulus package through Congress is likely to become increasingly apparent.  Many Senate republicans are already balking at the price tag and contents, adding more weight to the view of an eventual passage of a sub $1tn package of measures (see my explanation of why Republican support is needed). One of the most contentious issues is likely to be a federally mandated $15 minimum wage. 

At least, the Senate won’t be juggling the impeachment of Donald Trump, at the same time as debating administration nominations and President Biden’s fiscal proposal, with the impeachment trial now scheduled for the week of February 8.

The contrast between US and European data at the end of last week was clear in the release of Markit purchasing managers indices (PMI) data.  US PMI’s registered strong flash readings for January, with both the manufacturing and services indices rising while in contrast the Eurozone composite PMI fell in January, sliding further into contraction.  A disappointing UK retail sales report highlighted the pressure on the UK high street too. 

The reality is that many developed economies are struggling into the new year, with a sharp increase in virus cases including new variants, slower than hoped for rollout of vaccines, and vaccine production shortages, all pointing to a later than expected recovery phase. 

This week, the Federal Reserve FOMC meeting (Wed) will garner most attention in markets. A few Fed officials mentioned tapering recently, clearly rattling markets, as memories of the 2013 “taper tantrum” came back to the surface.  After tamping down on any taper talk Fed Chair Powell is likely remain dovish even as he expresses some optimism on growth.  Growth in Q4 will have looked weak and US Q4 GDP (Thu) will be in focus, with most components likely to have slowed.  A plethora of earnings releases will continue this week including key releases from the likes of Microsoft, AMD, Tesla, Apple and Facebook. 

A dovish FOMC will do no favours for the US dollar (USD), which came under renewed pressure last week.  However, risk assets appear to be struggling a little and should risk appetite worsen it could boost the USD, especially given extreme short positioning in the currency. Emerging Market currencies will be particularly vulnerable if any rally in the USD is associated with higher US real yields. 

Catching up with reality

Markets have had an exhilarating run up over recent weeks.  Since the start of the month the S&P 500 has risen by close to 7%,gaining around 58% from its March low, as the evidence of global economic turnaround has strengthened and the outlook for earnings improved.

Nonetheless, the rally in equities has meant that valuations are starting to look stretched again. For instance the price / earnings ratio on the S&P 500 has risen to its highest level since January 2004, perhaps hinting at the need for a degree of investor caution in the days and weeks ahead.

Other factors aside from the pace of the move also call for some restraint to market optimism such as the potential for escalation in trade tensions between the US and China, the imposition of regulations on banks and the timing of reversal of extreme stimulus measures. 

As the panic has left markets over recent months volatility has eased as reflected in the VIX index which has dropped to around its lowest level since September 2008, just before it spiked massively higher in a matter of weeks in the wake of the Lehman’s blow up. 

This has been almost perfectly echoed in the move in currency volatility, which has dropped to around the levels last seen a year ago for major currencies.  These levels are not quite pre-crisis levels but for the most part pre-date the collapse of Lehman Brothers, reversing almost all the spike in risk aversion that took place from a year ago. 

It is probably not too much of a stretch to state that having expunged the shock of Lehmans and the worst fears about the global economy from measures of risk and volatility the room for further improvements may be somewhat more limited.  This may be countered by the fact that economic data continues to deliver positive surprises relative to consensus, providing fuel for a further rally in risk appetite. 

However, a lot of good news must surely be in the price by now and it is likely that even the most bearish of forecasters has to acknowledge that an upswing in activity is underway. This ought to ensure that consensus forecasts catch up with reality, leaving less room for positive surprises and perversely less support for equity markets. 

The rally in risk appetite and equity markets has taken its toll on the US dollar which has had a gruelling few weeks during which the US dollar index (a basket of currencies versus USD including EUR, JPY, GBP, CAD, SEK and CHF) has hit new lows almost on daily basis.  Any pause in dollar selling driven by a softer tone to equities is likely to provide better opportunities for investors to take short positions in the currency given that little else has changed in terms of USD sentiment.   How far can the dollar drop?  Well for a start the April 2008 low around 71.329 for the USD index beckons and after that its into uncharted territory.

%d bloggers like this: