Fears of out-of-control inflation have been replaced by concerns of a sharp slowdown in global economic development, making for a very long, holiday-shortened week for investors in the United States. But is this new story correct? Long-term yields fell substantially as a Treasury debt rally turned into a buying frenzy. The so-called reflation trade, which had preferred shares of more cyclically sensitive corporations expected to benefit the most from rising prices and quickening economic growth, lost any residual wind.
What went wrong? According to Lauren Goodwin, economist and portfolio strategist at New York Life Investments, which manages $605 billion in assets, the shift in the market narrative has three key components. The first is a perceived shift in the Federal Reserve’s response to data, with investors no longer expecting policymakers to be as tolerant of economic overheating and increasing inflation as they once were, she explained. The second point is that, while economic growth is projected to continue, the rate of growth is expected to slow. Third, there are concerns that the spread of the delta and other coronavirus variations that cause COVID-19 may compel a new round of limitations, putting a damper on global economic activity. In a phone interview, Goodwin said, “Together, that’s a very different consensus market story than we had a few weeks ago, when the focus was all on stimulus and overheating,” adding that investors must now ask, “Is this new narrative the right one?” The true pain in the Treasury market this week came from a rally that drove long-term rates lower and prices higher. Much of the rise was due to Treasury bears who were afraid of inflation being compelled to cover their short positions, causing a feeding frenzy that drove the 10-year yield TMUBMUSD10Y, 1.359 percent to a five-month low below 1.25 percent on Thursday before ultimately relenting. However, observers said the action reflected reasonable concerns about the global economic growth forecast, at least in part. The S&P 500 SPX, +1.13% and Nasdaq Composite COMP, +0.98% both fell from all-time highs on Thursday, while the Dow Jones Industrial Average DJIA, +1.30 percent lost more than 500 points at its session low. Stocks recovered some of their losses by the close and then surged higher on Friday, with all three major indices setting new highs. The stock market reflation play was one of the victims. The small-cap Russell 2000 index RUT lost 1.1 percent for the second week in a row, while the tech-heavy Nasdaq-100 NDX, +0.71 percent gained 0.4 percent. The Russell 1000 Value Index RLV, +1.54 percent underperformed, sliding 0.3 percent, while the Russell 1000 Growth Index RLG, +0.85 percent increased 1 percent. “The ‘reflation’ and ‘rotation’ trades — associated with optimism about a rapid, broad-based economic recovery from the pandemic and higher inflation — has arguably been flagging since the end of the first quarter, but clearly took another hit this week,” said Oliver Jones, senior markets economist at Capital Economics. He pointed out that sectors like oil and financials, as well as variables like value, that gained the most from the reflation/rotation story, have underperformed. Jones stated that when supply restrictions cut into activity, confidence about the US economic recovery should peak. And, with China’s economy expected to continue to fail, global growth forecasts may be put under strain. China’s monetary policy loosening adds to concerns about slowing growth. At the same time, the US economy is on track to have a much stronger rebound than the one that followed the global financial crisis of 2008. And, he claimed, core inflation in the United States may be more persistent than previously thought. As a result, “the rotation/reflation trade label may become progressively less helpful in the future quarters,” he said. Parts of the trade, such as quick gains in most stock markets and outperformance by energy companies, are likely to be gone for the time being, he said, while the decrease in Treasury yields is likely a “overreaction” given the U.S. growth and inflation trajectory. In the following week, investors will be able to examine information on both inflation and growth. Tuesday will see the release of the June consumer price index, while Wednesday will see the release of the producer pricing index. Over the course of the week, a slew of other economic statistics will be released, including June retail sales estimates on Friday. Then there’s the start of the corporate earnings reporting season, which is likely to be another high point as profits soared in the second quarter compared to last year’s early days of the pandemic. After Friday’s record closing, Ryan Detrick, chief market strategist at LPL Financial, said, “With earnings season beginning off next week, the bar is set fairly high and corporate America better produce another spectacular quarter or there could be some disappointed bulls.” Prepare for peak earnings growth once the second-quarter numbers are released next week. According to Goodwin, investors must choose between following the old narrative, which favors cyclical stocks and short-term assets, or following the new one, which expects economic growth to be more sluggish and anemic, much like it was before the pandemic, favoring growth stocks and defensive sectors. According to Goodwin, the ideal reaction may be a combination of the two. In the short term, reflation is likely to have some room to run. Customers will begin receiving child tax credit payments later this month, while labor shortages may be alleviated in the following months when children return to school and extra jobless benefits expire, she added, while consumers have substantial savings. Growth and inflation are peaking at the same time, she said, and valuations are stretched across asset classes. The changing backdrop necessitates a more balanced approach to portfolios, she said, while preserving a cyclical tilt. Investors should focus on sectors and particular companies that can capitalize on changing trends and pass on higher costs to consumers in a more selective environment, rather than one where a rising tide lifts all boats, she added./n
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