Global Markets: is there now a Deflation Trade?

Only a few more business days to go in what has been a challenging Q3! Take profits or put more money on the table? It could go either way, with a hangover in Q4. In July, I wrote about ‘still waters running deep’ with the implication that investors would eventually have to face up to the longer-term impact of COVID-19 on developments that pre-dated it, including notably a weakening global economy, central banks’ running out of ammunition, bond and equity prices at unprecedented levels. If this sounds familiar it is because it is where we are still. Nevertheless and despite jittery outbreaks, equity markets in August were dominated by renewed confidence in momentum trading using call options reinforced by widespread FOMO.  Big Tech in the US was the main beneficiary of the punting but there were also strong gains in the sector in China and South Korea. With both Gold and Oil adding to their major gains in Q2 and the dollar’s weakening further, expectations of a ‘reflation trade’ began to build, seemingly prompting a major sell-off of sovereign and other investment grade bonds and some reshuffling into Japanese and German stocks as well as US cyclicals and midcaps. However, early in September movements in bond yields, Gold and Oil prices and the dollar started to reverse and even Big Tech stocks have been wobbling.

Now at the end of September, the momentum traders and their FOMO fellow-travellers have still not given up but bond yields are still falling, Gold and Oil are taking a beating while the dollar has pulled back around half of its losses in July and August. Moreover, COVID-19 is still very much with us. New fears are forming about the outlook for Employment in the advanced economies despite other economic indicators continuing to recover. Doubts are increasing that China’s growth will have, as in the past, spillovers elsewhere in the world. Meanwhile, not only is inflation subdued in most major economies (India is a notable exception), it is negative year on year in Italy, Spain, Australia, Thailand, Malaysia, Singapore and Hong Kong. Despite their avowed determination to stimulate growth and inflation, the world’s central banks do not seem to be expecting much success soon. The forward guidance of ultra-low official rates and government bond purchases for the indefinite future is surely also driven by a desire to reduce the cost (a.ka.a financial repression) of the fiscal stimulus that the central bankers are calling for.

The latest developments may not be sufficient to justify  a ‘deflation trade’ in the sense of a major stock market crash but it should help to dampen FOMO and leave the option punters out on their own in trying to push prices up even higher. China’s equity markets (including Hong Kong) do offer opportunities for those searching for growth (and inflation) but most of the best stocks already enjoy premium ratings. Bond investors still seem very willing to tolerate miserly rates on sovereign and investment grade paper while turning riskier  ‘High Yield’ into ‘somewhat less than High Yield’. The investment case for moving funds out of dollars will be harder to make, which will bring relief to the authorities in the Euro Area as well as many developing economies (except those who peg or ‘manage’ their FX rates). The inflation case for Gold has clearly stalled but there is still not enough evidence for the economic collapse case.

Overall, therefore, while a deflation trade currently lacks wide support it seems clear that any reflation trade is losing its shine. Investors still have to face the challenges of COVID-19, a faltering global economy and very stretched prices in equities and bonds. Santa Rally, anyone?