Reflation or Bust? The Case For and Against

Even before saying goodbye to 2020 impacted by COVID-19 and ushering in a hopeful 2021, reflation was firmly on the minds of investors. Buoyed by hopes of a successful vaccine roll-out and a return to some degree of normality, many investors have been trumpeting reflation as one of the major themes for 2021. With January almost in the books, this trade has achieved a certain level of consensus among speculators and money managers alike, so it is worth looking a little closer at the ongoing potential rewards and risks.

What the reflation trade looks like

The heart of this trade revolves around the US dollar; to be precise, a weaker US dollar throughout 2021. The combination of both monetary and fiscal stimulus is expected to translate to a strong rebound in growth. Other features of this reflation trade include a commodity bull market fueled by a weaker dollar, particularly in industrial metals, lumber, and agricultural commodities. This, as you may expect, is also necessarily a call for emerging markets to outperform their developed counterparts.

Within developed markets expectations are that bond yields will continue to rise, small-cap stocks are set to outperform large-cap names, as well as a broader rotation from growth into value. Essentially, the proponents of reflation are looking at 2021 which’s primarily characterized by a complete reversal of the themes we saw in 2020. In practice, this looks like a switch from gold miners to energy stocks, and a move away from technology and into financials.

Risks to the reflation narrative

There are some notable risks to this trade that should be kept in mind. With so much of the market buying into this narrative, any threat to this trade could lead to significant air pockets in markets and the possibility for a rapid unwind.

German bund yields appear to be giving the lie to the reflationary narrative. While US 10-year yields have rallied some 20% in January alone, German 10-year bonds have barely moved since October and have been trading within a 2% range since then. This disparity between the US and Europe is particularly relevant to the reflation narrative, as it suggests that what we’re seeing isn’t so much a synchronised global reflation, but rather commodity inflation driven by a weaker dollar. European equities have yet to test, let alone break their highs from February of last year. If this really were a global reflation, then you’d expect it to register in the EU, particularly in European equities due to them being sensitive to emerging market demand. This may mean that European equities are offering great value at the moment. Particularly with the FTSE 100, now that the UK has the Brexit tail-end risk behind it.

Other much-discussed aspects of this story are the notions of demand brought-forward and pent-up demand. Last year, locked down as most of us were, demand for services like entertainment, eating out, holidays, etc. was replaced by demand for commodities and finished goods. Savings levels increased, furlough and stimulus checks were banked with nowhere to spend them. Many of us embarked on home improvements or used that extra cash to upgrade our computers and other consumer equipment. This has brought forward demand in both commodities and finished goods, which may not hold throughout the year. If you built a conservatory in 2020 or bought a new television, you’re hardly going to do it again in 2021.

What about the service economy though? Couldn’t demand switch to services in 2021 as it shifted away from them in 2020? While many speak of pent-up demand in the services economy, it’s highly unlikely that a return to normality will see us flocking to restaurants, movie theatres, and all-inclusive holiday resorts at anything like the rate required to make up for all the lack of spending in those areas last year. If you normally eat out once a week and are prevented from doing so for three months, this is hardly going to translate to you eating out twelve times as soon as restaurants reopen in order to fulfill that pent up demand. You have to imagine that a large portion of that demand has been destroyed by its sheer inability to be filled.

Finally, while the vaccine roll-outs are enormously encouraging, we should all take a moment to remind ourselves that we’re dealing with a vaccination initiative that has brought products to the market at a speed that has never been seen before, with a novel virus that has already been reported to have mutated. As such, this is not the same as a routine tetanus shot. As far as vaccine risks are concerned, Israel will play the role of the canary in the coal mine throughout 2021, leading the world, as it currently does in COVID-19 vaccinations. Any hiccups in the efficacy of the vaccination is a tail risk that could impact risk markets. This is one key area to watch.

Simple ways to hedge against a failed reflation

The easiest and most obvious way to hedge against the reflation narrative is to have a part of your portfolio allocated to the US dollar. The euro is up some 15% against the dollar since March of last year and any threat to reflation is likely to lead to a reversal of this trend.

Gold is also going to be a part of this story, not only due to the possibility of a risk-off scenario but also because of a larger amount of fiat currency in circulation vying for the same hard assets. Dip-buying, in order to build a gold position throughout the year, is also going to be a good hedge. Gold traders would do well to keep an eye on the gold to silver ratio, as a global reflation would necessarily see silver outperforming due to its dual status as both a precious metal and an industrial commodity. However, investors also need to be aware that if central bank policy starts to normalise, the long-term appeal of gold will diminish and hurt the bullish case.

Finally, bitcoin specifically and crypto, in general, could also be considered as a possible hedge for the same reasons that gold and other hard assets are, but also because it has its own dynamics uncorrelated to the broader market, and it could function as part of a complete reworking of the traditional financial system. However, cryptocurrencies are very volatile and there is far from a clear consensus on how to value them. Risk must always be managed, but this is particularly true in the crypto markets. BTCUSD lost 25% of its value in one week during recent market trading activity, so traders must watch out for sharp volatile moves. Bitcoin investors should be prepared for large swings in their equities as well as recognising that BTCUSD is viewed by many professional investors as a bubble. That view alone will dissuade some of the more conservative investors.

Whatever the case may be, 2021 is shaping up to be a very interesting year in markets. We can only hope that we get to experience it from more than just the comfort of our homes watching it on our own television screens.

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HYCM is the global brand name of Henyep Capital Markets (UK) Limited, HYCM (Europe) Ltd, Henyep Capital Markets (DIFC) Ltd and HYCM Limited, all individual entities under Henyep Capital Markets Group, a global corporation founded in 1977, operating in Asia, Europe, and the Middle East.