Is the reflation trade already priced into markets?
Investors are betting that US stocks will lead the way as the global economy rebounds from Covid-19. But if you truly believe in the reflation trade, there are better ways to play it, says John Stepek.
We pride ourselves on being contrarian thinkers here at MoneyWeek. But I have to admit, it seems that our view that we’re heading for reflation next year, doesn’t exactly go against the grain. In fact, investors generally are uber-bullish right now. So should we be taking the other side of the trade? Let’s see...
In his Bloomberg email this morning, John Authers flags up an important issue that quite a few people have been raising in recent weeks. It's this: there is a very strong consensus around the reflation trade. Investors are exceptionally bullish for the year ahead. It is not a minority view. Indeed, it is anything but.
Why contrarian thinking pays off
Now, we're believers in the reflation trade here at MoneyWeek. But this consensus is something I feel I have to address. Because if you're a contrarian investor – and that's what we tend to think of ourselves as here at MoneyWeek – that's a big warning sign. When everyone is on the same side of the boat, that's when the boat tends to tip over.
Why? it's simple: markets work on expectations. They take everyone's view about what's going to happen in the future and turn it into prices. This is a pretty good way to do it. A free market incentivises individuals to contribute their information to the group mind. If you think the market is wrong, then at heart, what you are saying is that you have a better understanding of the world. You are better informed. And that means you have a good incentive to exploit that information gap by buying (or selling) and profiting when "reality" proves you right (or at least, that's what you hope).
With lots of people incentivised to give their conflicting views on the future, you should end up with an average that gives a pretty good approximation of reality. And that's normally what happens – it's hard to beat the market because the market tends to be just about "right".
However, as we're human, it doesn't always work like that. You can get swept up with the crowd, particularly if markets are going in one direction relentlessly (markets are "reflexive" – investors get information from the market and vice versa, so you can get into feedback loops). To cut a long story short, everyone can end up betting on the wrong outcome, which means that prices can get way out of line with reality. Which means that when reality bites, the market swings viciously – and the few people who avoided getting caught up in the frenzy (the contrarians), can make a lot of money (or at least avoid losing it).
That's the value of being contrarian and that's why – for example – I prefer to be a buyer than a seller of oil, at a time when everyone is saying that it's doomed, and ESG investing is being lauded in both moral and financial terms.
By the way, if you’re interested in reading more on the psychology of markets and the mechanics of contrarian investing, I wrote a book about it that came out last year – The Sceptical Investor. Makes a great Christmas present, fun for all the family, except maybe the chapter about investing and fear of death.
But I digress – what does it mean that the reflation trade is ultra-popular? Should we be betting against it?
Watch what people are doing, not what they’re saying
I get edgy when we’re part of a consensus. And I’m well aware that saying: “Yes, but” is a classic sign that you’re in denial. However, here’s a point I’ll make, and I think it’s a valid one: you don’t just need to watch what people are saying – you need to watch what they are doing.
If you believe the reflation story, then there is one very clear sector on which you should not be bullish right now. US stocks are wildly expensive at the moment, and the stocks that have led them to these heights are among those that have benefited the most from a disinflationary, Covid-19-wracked economy. If you truly believe in the reflation trade, then US stocks may be one of the worst ways to play it. Even if they don’t go down, just about anything else represents a far better “catch-up” bet on a return to global growth and inflationary pressure.
As Authers notes, “a major global reflation should more or less guarantee that the rest of the world, and particularly emerging markets, will outperform the US”. And yet, according to a survey of nearly 1,000 institutional investors by Jim Reid at Deutsche Bank, this isn't what they are betting on. They are definitely in "risk-on" mode, with huge optimism about the direction for stocks. But US equities remain their favourite way to bet on that trade.
Equities in general are popular on his survey (except UK ones, obviously). But commodities – the most reflationary asset of all – are well down the list, and barely changed on last year’s ranking. To go back to my oil example from above: if investors really believe that reflation is the order of the day, then why is the oil price still sitting at $50 a barrel? Yes it’s recovered, but this time last year it was closer to $80 a barrel. Is this an extreme bet on reflation we’re witnessing? I don’t think so.
If you believe in reflation, should the amount of negative yielding debt in the world still be at record levels? Financial repression is one thing, but markets aren’t even making an attempt to drive yields up. Is that an over-exuberant bet on reflation? I don’t think so.
Here’s what I think: markets feel positive and slightly giddy due to the vaccine news and the “government stimulus” storyline. But dazed investors are still betting on pretty much the same things they were backing before any of this kicked off. I’ll believe that markets are really growing irrationally exuberant about the reflation trade when Tesla takes a hammering and the Fed has to step in to stop US Treasury yields from spiking higher. No signs of that yet.
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