While off to a fast start in the first quarter, the reflation trade has taken a blow that puts its longevity into question. In simplistic terms, reflation characterizes an upswing in economic growth which sees both growth and inflation accelerate, often after an economic slump. In addition to rising growth and inflation, we also typically see interest rates rise with the direction of interest rates, growth rates, and inflation rates impacting pockets of the market in different ways. Typically, sectors of the market classified as “cyclical,” due to their variability around the business cycle, outperform the market during reflationary periods. This is why we progressively increased our client portfolios towards these cyclical areas throughout the first half of the year. Our thesis is that the economy would run hot for an extended period as the U.S. economy reopens, consumers hit the roads and increase spending on services, and manufacturing runs hot to keep up with existing demand and to replenish inventories.
This is exactly what we are seeing with gasoline demand this year, which is at the highest level during the year ever, well above 2020 and 2019 levels. The sharp increase in gasoline demand has pushed U.S. crude oil inventories below their 5-year average supporting strong oil prices this year. Despite months of the economy being reopened, inventories for vehicles, appliances, and general retail inventories remain at decade lows. There are growing concerns about how the economy will fare once unemployment and pandemic assistance checks stop, but we do not share those concerns. The government sent out excessive amounts of stimulus, providing consumers more than what was needed which is clearly seen when looking at credit card delinquency rates. Delinquency rates RISE, not fall during economic downturns…but not this time. Currently, credit card issuers are seeing delinquency rates at the lowest level ever as they declined throughout the COVID-induced lockdowns.
Given the U.S. consumer entered this year with a healthy balance sheet, our view is that the consumer would have the capacity to increase its credit exposure as government assistance begins to wane. We are already seeing this as the May consumer credit report showed the largest monthly increase in consumer credit outstanding ever, rising over $35 billion dollars (top panel below), largely stemming from a sharp increase in nonrevolving debt (bottom panel below).
The strength of the U.S. consumer is also showing in more recent data. Retail sales for June surprised to the upside, beating all Bloomberg survey economist estimates. The median estimate was for a 0.3% decline for June while actual sales jumped 0.6% for the month. The report showed a continual shift in spending habits away from goods and more towards services as the economy reopens.
When Fundamentals and Technicals Do Not Agree – Remain Flexible, Remain Humble
Like the old Bible verse, “whoever exalts himself shall be humbled, and whoever humbles himself shall be exalted,” if you fail to remain humble when investing, the market tends to have no problem rectifying that for you. Clients who have listened to our commentary and read our writings over the last few months know our views that reflation should continue well into the later half of the year. And, as highlighted above, the fundamentals have largely validated this view. However, the same can’t be said of the market. Interest rates have stopped rising despite elevated levels of inflation. Cyclical areas of the market are lagging behind the major indices such as financials, industrials, materials, and energy; and some commodities have undergone sizable corrections of late. Something is amiss in the markets where fundamentals and market prices aren’t lining up, which appears to have begun in just the last 4-8 weeks. A case in point are energy stocks and oil prices. Since the start of June, oil prices are up 5.5% through July 15th and yet the S&P 500 Energy Index is DOWN 6.43%, underperforming oil prices by more than 10% in one month. Another example is the silver market where silver is up 1.7% since the Fed’s meeting in the middle of June and yet silver stocks (using the Prime Junior Silver Miner ETF, SILJ) are down nearly 8%, underperforming silver by roughly 10% in one month alone.
One of the culprits of this dichotomy in our view is declining liquidity in the U.S. financial system which appears to have peaked in the March to May time frame. Over the last year, as the U.S. economy was reflating, bank reserves shot up as did long-term U.S. interest rates as the two moved in sync. However, the 10-year U.S. Treasury yield peaked in March at the end of the first quarter and commercial bank reserves held at the Federal Reserve peaked two weeks later. With reserve balances failing to expand since April we have seen long-term interest rates (red line below) trend lower as shown in the following chart.
At the same time, we’ve seen the level of cash drained from the U.S. banking system through overnight repurchase agreements build momentum, rising to over $1 trillion at the end of June and remaining over $700 billion dollars each night this month. While there could be several reasons for this massive amount of funds exiting the U.S. financial system, one thing is clear is the negative impact this is having on the reflation trade on our client portfolios.
One of the supports for the reflation trade was a global economy opening up from lockdowns as COVID-19 infections began to decline with increasing vaccination rates across the world. We are currently witnessing a trough in the decline of active global COVID-19 cases which puts the global economic momentum in jeopardy. We entered 2021 with 27 million active cases of the virus which nearly doubled before peaking at 53 million in the middle of May before vaccine rollouts started to dent the trend. However, with the proliferation of the delta variant and a slowing in vaccine administrations, active global cases have been steadily rising over the last month and are on the verge of hitting a new high and, with it, the risk of renewed lockdowns that would impact economic growth. Los Angeles is back to requiring mask-wearing indoors for all people, even those vaccinated. Parts of Australia are returning to lockdowns. Thailand is considering more lockdown measures to contain their outbreak, and Israel is requiring masks indoors once again. There are other parts of the globe moving in the wrong direction as their cases rise and with it comes the potential for stalling economic growth and the increased risk that the reflation trade will end until the trend in rising lockdowns reverses.
On the positive side, we have greatly improved treatment for COVID which has dramatically reduced death and hospitalization rates. The U.K. is a perfect example of this. As you can see below, the daily change in new cases is quickly approaching the highs seen at the beginning of the year and, yet, the daily change in new deaths has remained low. Cases typically lead deaths by three weeks and when we advance forward the U.K. daily change in cases, it shows that we should have already seen a sizable jump in new deaths. Thankfully, that's not the case. If this remains to be true, this new wave of COVID cases is likely to have a lesser impact than in prior waves. That said, we still expect this to have an impact on mobility and economic output which we will be monitoring closely going forward.
It appears as though the peak in U.S. financial market liquidity coupled with a stall in the global economy reopening due to the surge of COVID-19 cases is putting an end to the reflation trade and with it comes rising risk to the financial markets. Because of this building risk to the markets, we have drawn lines-in-the-sand for our vulnerable reflation trades and have started raising a bit of cash to lessen the negative impact. There is no telling when this temporary liquidity drain will end nor when COVID-induced lockdowns will reverse, but when they do it is likely to have the opposite of its current impact. Reversing the liquidity drain in the U.S. financial system should add cash back into the banking system and lead to a rise in interest rates and breathe life back into the reflation trade. A reversal of COVID-induced lockdowns should help reflate global growth and provide renewed support to the reflation trade.
Two of the biggest supports to the reflation trade are rising interest rates and a falling US Dollar (USD). Therefore, these two markets are ground zero in determining when this setback to the reflation trade is likely to end. The 10-year UST yield peaked on March 30th at 1.77% and has declined all the way down to 1.3% as of July 16th. So far, there are no signs that the decline in interest rates that began in the second quarter has ended but we will be watching the technical situation closely for signs of a reversal.
Since last November, the Bloomberg Dollar Index has been in a sideways trading range and has not given a clear edge to either commodity/reflation bulls or bears. Should the USD Index break above this trading range it would imply that global growth is cooling more than anticipated and/or global financial liquidity is continuing to dry up and will likely have negative implications for the reflation trade beneficiaries. Likewise, should the Dollar Index fall below this trading range that would signify that the reflation trade is resurfacing and the outlook is brightening on global growth.
We are fully convinced that the US and global recovery is being bent but it is not broken. We are still very early into the economic recovery in the U.S. and globally as unemployment rates remain elevated and global central banks are far from turning restrictive. While it is true global central banks are incrementally removing stimulus, they remain far away from being considered restrictive. We view the current shifts as merely a pause in the reflationary recovery and not a complete derailment of it, and are thus likely to resume at some point and we have identified two market markers to judge these transitions highlighted above.
The big unknowns are how far and how long will the decline in US financial system liquidity will go as well as when will we see a final peak in COVID cases and move back towards reopening the global economy versus shutting it down. Given these two large unknowns, we will continue to monitor the positions in client accounts and raise cash where and when necessary as we bid our time to reposition for a resumption of the global recovery. If you have any questions regarding our portfolio strategy, please do not hesitate to reach out to our wealth management team.
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