Rotation vs. Risk Sentiment
Summary: We discuss the ongoing reflation thematic and associated rotation that is playing into recent market moves.
Despite the sell-off in tech grabbing headlines, under the hood the reflation rotation is firmly intact. Global growth continues to rebound and breakevens are at the highest level since pre- 2008 as vaccination programmes roll out, COVID-19 retreats, restrictions are wound back, and economic activity normalises.
As economies reopen, the pickup in growth alongside recovery in business conditions and confidence as activity normalises is one of the pillars of support for ongoing recoveries, a synchronised global growth upswing and sustained gains for reflation trades. In fact, the reflationary pulse is so strong investors are increasingly concerned about inflationary pressures making for a fragile equity environment as global bond yields rise. Yields will continue to rise with global reflation, but given their low base, and the strong outlook for growth, equity prices can rise in tandem, primarily for sectors of the market most leveraged to ongoing economic recoveries – commodities, materials, financials, industrials etc. and hitting speculative portions of the market like bubble stocks that rely on low rates to propel their infinitesimal valuations. The higher that yields go, the more pressure is on that rotation. Also expect the rotation from “Covid winners” to “Covid losers” to continue along with the shift from growth to value plays as the economic cycle accelerates out of the crisis trough.
The economic recovery has begun, and the inflation uptick is already here. Recent PMI surveys point to inflationary pressures with supply bottlenecks, increasing input costs and demand rebounding. Commodity prices continue to push higher. And these pressures are feeding through to survey data – ISM, global PMIs, China PPI etc. – soon to be visible in headline CPI indices. In addition, consumers are ready to spend, Covid fatigue has set in and the pent-up demand bounce back is kicking in, further fuelling the price pressures already creeping through the system. Disposable income has risen during the pandemic and we are looking at an aggressive demand bounce back accompanying vaccine rollout, intensified by Covid fatigue. In the US household spending expectations are at a 4-year high against a backdrop of elevated savings. In Australia, the better-than-expected 4Q GDP was led by households spending savings built up from stimulus payments/lockdown and spending up on discretionary items.
As we have posited previously, the reflation rotation is on as economic recoveries resume into Q1 against the backdrop of ongoing fiscal spending and vaccine rollouts with inflationary pressures rearing their head.
Toward the end of last year we wrote - for pro-cyclical stocks there is more room for normalisation and these sectors can look past immediate risks … Rendering opportunities to play the ‘economic reopening’ and cyclical rotation … (industrials, materials, miners, travel and leisure, energy etc., emerging markets - favoured EWZ, EWW, THD, small caps - IWM) Providing a relative opportunity for outperformance …Relative togrowth/tech and momentum names that have front-loaded several quarters of gains. The best opportunities in the coming months are likely to come from those most leveraged to economic activity normalising that have low expectations like industrials, materials, travel and leisure, and energy. In addition, commodities with the trifecta of drivers supporting the outlook through to 2021 - Supply deficits, policy tailwinds from infrastructure spending and green electrification trends and on the macro side tailwinds from a weaker USD and rising inflation.
Looking at the sectors, energy has outperformed tech by almost 40% YTD. The Dow Jones closed at record high this week vs. the Nasdaq which has suffered a more than 10% drawdown of recent ATHs. This as investors pivot away from tech during recovery phase of cycle, toward cyclicals, the new market stalwarts. Economic optimism works against the long duration tech trades and supports pro-cyclical allocations. The SPX can return to all-time highs but with a different composition – a changing of the guard. SPX breadth is at the highest level since November and without Facebook, Amazon, Apple, Microsoft and Tesla, the index would’ve been up by 0.2% overnight, instead of closing lower.