The reflation trade and three yield curve outcomes

By Edward Harrison On Jan 15, 2021

As the new year has begun, I’ve been thinking a lot about the ‘look through’ narrative that sees the post-pandemic light at the end of a dark tunnel. While I have a lot of sympathy for the thought that pent-up demand for services will drive growth in some sectors like travel, where I will definitely be a part of that increased demand, I think the tunnel is long and the move to reflation thinking is premature.

The data released today out of the US highlight this. And so, I want to talk the reflation narrative in the context of three specific outcomes for bonds.

The data

First, let’s look at the few data points we saw this morning.

Retail Sales Ex Gas/Autos (MoM) (Dec): -2.1 versus -1.3% in November
Retail Sales (MoM) (Dec): -0.7% versus expectations for -0.2& and -1.4% in November
Core Retail Sales (MoM) (Dec): -1.4% versus -0.1% expected and -1.3% prior
PPI (MoM) (Dec): 0.3% versus 0.4% expected and 0.1% in November. YoY PPI now at 0.8%
Core PPI (YoY) (Dec): 1.2% versus 1.3% expected and 1.4% in November
NY Empire State Manufacturing Index (Jan): 3.50 versus 6.00 expected and 4.90 prior

What you’re seeing is a weak consumer leading to weakening economic output numbers and lessening producer price pressure in the midst of an economy that already has a huge output gap and slack demand for labor.

This is a disinflationary or deflationary economic environment.

The trade

As I write this, US equity market futures are down slightly, as are US 10-year bond yields. But prior to this, we saw a run-up in yields to has high as 1.19%. And we had seen a monster equity market rally that coincided with the election result and the first vaccine news announcement. It was if the news of a transition of government and a vaccine showed people that the pandemic phase would soon pass and we would be off to the races economically.

The trade, put simply, was reflation – Equities up, commodities up, oil prices up, bond yields up, credit spreads down, US dollar down. And the earnings announcement from JP Morgan today is in line with that thinking. They showed a record $12 billion in earnings including $3 billion from having over-provisioned for loan losses which are not coming due. That speaks to a more benign outcome than expected during the pandemic. And so, in that context, it makes sense to believe we can power through to the end of the dark winter via Biden’s proposed $2 trillion fiscal stimulus and Fed largesse.

That’s been the trade. And in equity markets, it’s been the trade since the Fed intervened, to be fair. The S&P500 is up to 3800 from below 2200 in less than a year, about 70%. The Nasdaq bottomed at just over 6600. It more than doubled in that time, trading now just down to 13,100. That’s the type of rally we generally have only seen at the tail end of manias. And this is happening against the backdrop of an economy 10 million jobs short, 11.5 million jobs below its pre-crisis trajectory that just saw over 1 million new jobless claims filed in the last week. The disconnect is stunning.

Bonds (and stocks)

But let’s not talk about equities here. Let’s talk about bonds because the data point to economic weakness, output gaps and disinflation for the foreseeable future. And given the logistical problems we’ve seen in the rollout of vaccinations, as a healthy non-elderly American, I could be sat right here a year from now unvaccinated and social distancing exactly as I am today.

To me that speaks to lower for longer. And it speaks to inflation being held in check — meaning it speaks to a flattening yield curve where the overnight rate is pinned at zero and expectations for rate hikes or inflation are diminishing. So, I haven’t given up on the bond bull market just yet. Nothing I am seeing suggests it is over. More likely, we have just seen a head fake, giving you a better level to enter a bond bullish trade.

More broadly though, I see three scenarios:

Scenario #1 is the one we were on until now where the yield curve was steepening before the bullish economic outcome had crystallized. If that trajectory continues, that’s a situation where you could have weak economic and earnings data juxtaposed to rising yields and discount rates. Eventually, this is kryptonite for growth stocks because discounted cash flow models of their earnings are heavily weighted into the future, making those higher yields and discount rates a headwind. Markets ‘looked through’ this fact as the yield curve steepened due to reflation hopes. But how long can the market look through steepening in a punk economic situation without eventually puking? I think we were close at 1.19%
Scenario #2 is where the yield curve steepening is arrested, stopped in its tracks as we await further progress on vaccination. And more steepening occurs only when its clear that we are at or near the end of the tunnel with pent-up demand actually a fact and not a rumour. That’s a scenario where the steepening is occurring because of an economic uplift that boosts earnings. And so, it shouldn’t hit shares as a result.
Scenario #3 is the one I mooted above, where the market susses out that true inflation is nowhere and the lack of consumer demand means weak economic growth and earnings. The yield curve there flattens, making discount rates lower and only potentially buoying the shares of companies that can benefit in the slow growth environment (if any). The risk in this scenario is that earnings multiples more generally contract as it pops the bubble in reflation hopes.

My view

I lean toward outcome number three, of course. But I leave the door open for the other two, secretly hoping for outcome number two. But, remember that hopes and reality are two very different things. And so, I see outcome three as more realistic than the other two.

The key questions in all of this are two-fold.

Question one: is past prologue in terms of the JPMorgan loan loss reserve reduction? JPM’s earnings are telling you fiscal stimulus and the Fed prevented worst case outcomes. Will that continue to be the case? If so, companies with either good earnings prospects in all economic environments or good balance sheets should benefit irrespective of what happens to yields.

Question two: are we at the tail end of a mania where earnings multiples contract as a result of euphoria turning to fear? Jeremy Grantham recently penned a piece suggesting this is where we are now. His view: Last dance! Last chance for romance. Soon the love fest will be over. And in his view, loving a manic market is dangerous. To quote Donna Summer, “cause when I’m bad, I’m so, so bad”.