The prospect of another US fiscal package of $1.9-trillion, equivalent to 9% of the country’s GDP, has provided further ammunition to a global rotation trade that has been in play for months now.

The rotation from defensive assets into those that thrive in a global growth environment has prevailed since November and was only briefly stalled by the disruptive retail investor foray into Gamestop, and other lesser-spotted shares in the last week of January.

The rotation trade is underpinned by expectations of a return to economic growth in 2021 enabled by vaccination rollouts globally. Importantly, it is also inextricably linked with expectations that inflation will accompany the growth story and its associated return of demand.

Beneficiaries to date have been equities in both developed and emerging markets. This year, the gap between the developed and emerging market stock market performances has been widening. For instance, South Africa’s All Share Index has gained 9.4% year to date — more than a five percentage point lead on the S&P 500 Index. 

Optimism about the pick-up in global growth, ongoing support from massive, and likely growing, developed market fiscal policies and expansive monetary policy for the next couple of years has seen SA equities pick up the pace and surpass their pre-Covid levels. Over the past year, the All Share Index has increased an impressive 17.1% during an extremely trying economic period.

But how robust are the economic underpinnings of the rotation trade and what risks are there to the present optimistic outlook for inflation-beating growth assets?

BNP Paribas analyst Nathalie Benatia says: “It, along with the prospect of vaccines, largely explains the rally in risk assets since. The same conviction will likely be underpinned by the latest vaccine development news and the initial encouraging results on acquired immunity, even though questions remain over the pace of vaccination.”

The prospect of immense fiscal stimulus from the country that counts the most for the rest of the world, the US, is particularly encouraging for the reflation rotation trade. The likelihood of US President Joe Biden’s $1.9-trillion fiscal package is becoming a reality now that he has decided to go ahead without the bipartisan support he was hoping to get. The funds could be disseminated as early as March. 

Benatia points out that if the size of this stimulus package is added to the package voted through in December, it would amount to the equivalent of 13% of US GDP. That’s in addition to the 10% of GDP rescue package that was quickly put in place as the pandemic took hold in the second quarter of 2020. Bloomberg Quintile notes that the total deficit increases are way larger than President Obama’s American Recovery and Reinvestment Act of 2009.

Predictably, there has been a bevy of high-profile economic commentators who have voiced their concerns about the extent of the fiscal stimulus; the most stinging of which was Larry Summer’s prediction that it would invoke the worst inflation in a generation. However, as pointed out by Benatia, “newly appointed Treasury Secretary Janet Yellen argues that “the smartest thing we can do is act big’’ on government spending in the face of a longer and harder recession”.

The jury is still very much out on whether inflation is due to make a comeback and become an intractable feature of the post-Covid economic landscape. Bond market investors certainly think so, with inflation expectations becoming hardwired into fixed interest assets in the US and at home, where inflation-linked bonds are looking relatively more attractive than nominal bonds, even though inflation is still below the SA Reserve Bank’s target range.

There have already been early signs of inflationary pressures in the US and Europe, and recent oil price increases add to worries that input prices will rise as a result. Rising price pressures globally would soon find their way to South Africa.

Benatia doesn’t expect a sustained acceleration in inflation, but that erratic data in the early part of 2021 could affect investor sentiment. Thus she believes that investors will need further evidence of central banks’ determination to maintain highly accommodative monetary policies and prevent inflation expectations from upsetting sentiment in bond markets.

In an article on the reflation trade, BloombergQuint’s Justina Lee captures the dissenting views on inflation: “Some investors contend that the no-expense-spared response by governments around the world to Covid and vows by central banks to keep rates lower for longer has put economies on course for inflation on a scale unseen in decades.

“Others say the pandemic is only intensifying trends seen in recent years, where price increases have been absent thanks to weak economic growth, demographics and technology.”

While inflation could pose a very real economic problem for the world economy and policymakers down the line, for investors, prospects of inflation are merely the other side of the reflation coin and will add further fuel to the rotation into growth-propelled assets. An absence of inflationary pressures would take the wind out of the sales of the reflationary trade.

According to BNP Paribas analyst John Carey, other risks that stand in the way of a prolonged reflation rally in risk assets include the impact of tighter lockdowns on economic growth prospects and a variety of vaccine-related stumbling blocks.

Potential problems include vaccine programmes advancing more slowly than expected, which has already been evident in the US, Europe and many emerging markets, and the emergence of vaccine-resistant strains, as evident in South Africa’s decision to put a hold on rolling out the AstraZeneca vaccine because tests show that it has low efficacy in combating the highly infectious strain of the virus that is believed to have originated here. The reluctance to get vaccinated in certain segments of the population could also pose a material risk to the growth story.

Real as these risks may be, however, Carey points out that potentially negative developments “appear to be getting a lower priority in the eyes of the markets at this point”.

The age-old problem is that investors have a well-worn tendency to underreact to adverse developments until they change their mind. March 2020’s surprise financial market meltdown followed by an even sharper melt-up is a good case in point. So putting all your bets on the reflation trade investment strategy of the moment may not be the wisest of decisions. DM/BM