After three months of steady rotation in financial markets, reflation-driven market action in April has paused, if not contracted. Reflation and reopening themes across and within asset classes, which had been outperforming strongly up until mid-March, have lost momentum. Pandemic woes in Europe and doubts about the scale of inflationary pressures have left investors scratching their heads and asking whether the rotation has run out of steam or if it is just taking a breath. The answer might not be as clear-cut, but rather a subtle mix of factors depending on the asset or sub-asset class in question.
Further macro improvement ahead
The latest round of economic data leaves no doubt as regards to the strength of the economic momentum, on both the growth and inflation fronts. While the first seems to buoy risk appetite, the second is being largely ignored, with signs of apparent complacency toward price pressures. Our proprietary Nowcaster indicators reflect above average levels of economic activity but still indicate a very high probability of inflation surprise over the year to come, as described in many of our previous publications. In the US, production expectations (measured by the Institute for Supply Management surveys) have hit their highest reading since the early 1980s and retail sales jumped more than 8% month-on-month in March, one of the largest increases on record. Moreover, the CPI beat all expectations as the US consumer finally started to unload the phenomenal amount of savings put aside for a year.
Hence, fundamentally, there are good reasons for the strength in growth-related assets but inflation does seem to be at odds with current market pricing. Looking up trends in web searches for the keyword “inflation”, it looks like the peak was reached in early March and searches have now receded to average levels. The peak coincided with the moment when the rise in interest rates paused and consolidation began. Central bankers played a key role in toning market reactions by holding their stance and “transient” rhetoric steady, reiterating their intention to accommodate a temporary inflation overshoot above target levels and implying no undesired changes in monetary stance in the short term. We remain of the view that inflation will be stronger and more durable than anticipated, and that mispricings exist in certain asset classes, especially sovereign bonds. Therefore, we see recent price action in inflation-related assets as a short-term pause rather than a more durable change in our core scenario.
Sentiment remains bullish, a pause in the risk-on context?
Although good reasons can be found to validate investors’ optimism toward risk assets, both in terms of macro and micro fundamentals, the question of exuberance and complacency is legitimate. That is, how much of the positive news is already factored into asset prices, and is there excessive optimism in certain asset classes? Equity indices have been reaching new highs, boasting stellar returns after only three and a half months into the year. As of 21 April, the MSCI World index is up 10.3% year-to-date, the second best performance over the period in the last 20 years. In terms of velocity, one-year rolling returns of most major indices are all in the highest percentiles on record. The MSCI global gauge of stocks is up more than 50% year-on-year, 23% above its pre-Covid peak.
In addition, various bull/bear indicators have also reached extremes, while flows in equity funds have skyrocketed, all pointing to extreme optimism. In the meantime, one asset class that had remained outside of the global rally, volatility, finally receded to pre-Covid levels. The recent regime shift in implied volatility, pushed the VIX index down to 16 (2018-2019 average) from an average of 24 in Q1 of this year. Other measures of the volatility complex have also meaningfully dropped, such as put-call ratios on US indices, skewness (measuring the cost of downside options versus upside options), and the volatility of volatility. This is indicative of increased confidence in the future as demand for hedging decreases. Relative strength index (RSI) indicators on certain stock indices have reached overbought levels too, usually signs of market exuberance. So for now, we observe no pause in risky assets broadly, even if the focus has now shifted to segments that lagged earlier in the year, predominantly volatility.
Yet action is taking place under the surface
Under the surface, in spite of very strong global returns (the MSCI World AC is up 4% month-to-date as of 21 April), the reflation-triggered rotation has been shaken strongly. The Russell 2000, one of the main reopening trade proxies, abandoned more than 5% relative to the S&P 500. From 15 March, the small cap index gave back all of its 14% relative outperformance over a 30-day period. More than a pause in one of investors’ favourite reopening trades, we are seeing a major reversal, driven by fears surrounding the sustainability of the Covid-19 vaccination campaign and relative valuations.
The reflation pause can also be observed in the fixed income space. Sovereign yields and inflation breakevens have stabilised globally since mid-March. The yield on the Bloomberg Barclays Global Government Bond index surged to 0.9% during Q1 and still hovers around the same level today. In the US, the closely watched US 10-year yield rose 125bps from August last year to 30 March, reaching 1.8% to finally close the gap with pre-Covid levels, seven months later than equity counterparts. Since then, the US 10-year yield has contracted 30bps, as long-term investors saw an opportunity to re-enter the asset class at more attractive carry levels. Inflation breakevens followed the same route, especially on short-dated tenors, with a peak in March and stabilisation thereafter.
Therefore, there has been a pause in certain reflation/reopening themes but in our opinion, the trend should resume over the medium term. Nominal yields and reflation-driven assets/sectors should break higher as macro and micro fundamentals continue to surprise to the upside. With 6% nominal growth expected in the US and 2.5% inflation, the dislocation with interest rates is too large to be sustainable. Central banks, especially the Fed, will guide investors cautiously but surely through the next phases of monetary action in Q2, developments in the health situation will be confirmed and macroeconomic optimism will continue to be seen in the real economy.
World Growth Nowcaster
World Inflation Nowcaster
Market Stress Nowcaster
- Last week, our World Growth Nowcaster continued its remarkable increase, supported by both US and European data. Recession risk is solidly anchored at the “very low” level.
- Our World Inflation Nowcaster paused last week after a three-week rise. It has now reached very elevated levels, reflecting very high inflation surprise risk.
- Our Market Stress Nowcaster edged higher last week, mainly as implied volatilities were marginally on the rise.
Sources: Unigestion. Bloomberg, as of 22 April 2021
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