This week, inflation data in both the UK and the US has come in a lot stronger than analysts had expected.
This comes at a point when most investors were starting to believe the idea that inflation is “transitory”.
So what happens now?
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The reflation trade has been hammered in recent months – but it might be time for a shift
As we discussed last week, the big debate in markets has morphed somewhat from being between deflation and inflation, to being whether inflation is “transitory” or whether it’ll turn into a longer-term, more durable problem. (Here’s the background to that discussion).
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It’s become clear in the last couple of months that investors had recovered from their initial bout of concern (or optimism) about inflation making a durable comeback.
You could see this happening in the market. Most commodities fell (except oil, which is a bit of a special situation at the moment). Growth stocks started to perk up again (a good example is that the Amazon share price has “broken out” higher in recent months and is now up nearly 25% on its March low), while “value” stopped being the winning trade.
You can also see this reflected in the swinging sentiments of global fund managers. Bank of America’s monthly survey of the people who move the world’s investments around showed that inflation expectations had collapsed after peaking in April this year. (I explain why this survey is such a useful sentiment indicator here).
In other words, over the last four months or so, fund managers have been shifting to the view that inflation will be “transitory” right enough. We’re now at the point where 70% of respondents agree that it’s “transitory”.
This shift in sentiment was probably aided by the sense from the most recent Federal Reserve minutes that some Fed members were getting edgy, and rising concerns over the impact of new variants of Covid.
As a result, the “reflation” trade – betting on value stocks over growth, being long precious metals and avoiding government bonds – had not only peaked but reversed (if only a little).
As we often point out about this survey, it’s worth taking the opposite side of the most extreme views. That’s not necessarily because they’re wrong (though they often are). It’s because those are the views that will be most mispriced.
What’s the logic here? You might believe that inflation is not the most likely outcome here. But if it’s more likely than the market currently thinks it is, that means inflation trades are undervalued. Any surprises to the upside (like the ones we’ve had this week), will result in a bigger reaction as markets scramble to price in the new data. And as an investor, you want to be where the undervalued investments are.
And on that front, after the latest data – and the Fed’s apparently relaxed attitude towards it – I suspect that the reflation trade might get back on the front foot.
The Fed would rather that inflation stayed ahead of interest rates
Yesterday we learned that UK inflation is rising at a rate of 2.5% a year, which was higher than the expected 2.2%.
Probably more importantly, earlier in the week, we learned that US inflation is rising at an annual rate of 5.4%, a lot more than expected. Even more importantly, the rise was pretty chunky regardless of which measure is used to try to massage the figures lower. For example, “core” US inflation was still up 4.5% year on year.
What’s probably more interesting is the market reaction to all this. Just a month or so ago, higher-than-expected inflation figures unnerved markets somewhat because they thought it meant that the Fed would raise rates more quickly than previously expected.
However, that assumption has now been priced in. Meanwhile, the Fed has been walking back the idea that it will move quickly on rates. So on the one hand, markets are still primed to expect inflation to be “transitory”, and they’re also less trigger happy about the idea of the Fed raising rates fast.
From that point of view, one of the more interesting reactions came from gold. Gold is often seen as a hedge against inflation, but that’s an oversimplification. It’s more accurate to say that gold does well when “real” interest rates (that is, interest rates adjusted for inflation) are falling.
In other words, gold does well when inflation is rising more rapidly than interest rates, or falling more slowly than interest rates.
So if inflation goes up but markets expect central banks to then react by raising interest rates in a draconian manner, that won’t be good for gold. Whereas if inflation goes up, and markets start to think central banks will ignore it, that’s more likely to be good for gold.
What we’ve seen in the past week or so is nothing spectacular. However, gold has held its ground and then moved a bit higher after the inflation data.
This was no doubt helped by Jerome Powell’s testimony in front of US politicians, which followed the data release, in which he emphasised the temporary nature of the inflation increase. He also emphasised the Fed’s new focus on “maximum employment”, which is clearly still a way off.
In other words, he showed no sign that the Fed will “jump the gun”.
What markets aren’t yet convinced of – but what I suspect will be the overall outcome – is that the Fed will want to lag inflation for as long as possible. And it’s not until inflation becomes a pressing political problem that there’s any risk of the Fed “getting ahead of the curve” on inflation.
The point is that “financial repression” – which ultimately boils down to keeping the rates paid to lenders lower than inflation – is now the name of the game. That has to be done by stealth. The only rule about financial repression club is that you don’t talk about financial repression club.
So conditions for gold and other assets that might do well during periods of inflation should remain positive, although it might take markets a while – and some more expectation-trouncing inflation prints – to grasp that.
And if you want to know more about financial repression and what could happen next, listen to the MoneyWeek podcast tomorrow. Merryn interviews one of MoneyWeek’s favourite analysts, Russell Napier, all about his current views. And before you listen to that one, you might want to catch up on what Russell told us back in December. You can listen to that podcast here.
