Home Forex Reflation trading is the new bullish narrative

Reflation trading is the new bullish narrative

by SuperiorInvest

Economic “reflation” is becoming the next bull narrative as stock valuation gains continue to outpace earnings gains, at least according to Gold Sachs and Tony Pasquariello.

“If GS is right on the big calls, the macro backdrop will remain favorable: the US economy should continue to grow well above trend (accelerating as the year progresses) with three adjustment rate cuts along the way. Not to obscure the moral of that story: the Federal Reserve is ready to ease its policy… toward a rebound. While the Fed’s speech this week had a somewhat hawkish slant, the House’s vision for 2024 remains intact.”

Interest rates and commodity prices have risen in recent months. Unsurprisingly, the bullish narrative supporting that rise has gained traction.

Curiously, this “reflation” The narrative tends to resurface on Wall Street whenever rising commodity prices need to be explained. Notably, the last time Wall Street focused on reflation trading was in 2009, as the WSJ noted:

“The most talked about investment strategy today is not putting money in a mattress, it is the reflation strategy. the bet that the global economy will recover, raising interest rates and commodity prices.”

While “reflation trade” It lasted about two years, failing quickly as economic growth returned to around 2% growth along with inflation and interest rates. As shown, oil and commodity prices have a very high correlation.

The fundamental reason is that higher prices reduce economic demand. As consumption falls, so does demand for commodities in general. Therefore, if raw material prices are to “reinflate” As shown, this will depend on stronger economic activity.CRB Monthly Chart

As such. Reflation trading depends on a global resurgence in economic activity, generally associated with economies recovering from a recessionary period. However, the United States never experienced a recession.

As discussed in “,” Despite numerous recessionary signals, such as the inverted yield curve, manufacturing data, and leading economic indicators, the economy avoided recession thanks to massive government spending. This is:

“One explanation for this has been the increase in federal spending since the end of 2022 as a result of the Inflation Reduction and CHIP Acts. The second reason is that GDP was so high relative to $5 trillion in previous fiscal policies that the lag effect is taking longer than historical norms to resolve.”

Federal tax revenues vs. GDP vs. spending

While economists focus on the “reflation trade” We must answer whether there is support for more substantial economic growth. This is the only determining factor to determine whether the ““reflation trade” You can continue.

Is reflation behind us?

Interest rates and inflation have risen recently, driving investors towards gold and commodities. However, the rise in precious metals and commodities is more a function of speculative exuberance than an economic resurgence. As discussed in “,”

“In other words, the stock market’s “buy anything that’s going up” frenzy has spread from a handful of AI-related stocks to gold and digital currencies.S&P 500 vs gold

In particular, the rise in gold, commodities and interest rates corresponded with stronger economic growth starting in the third quarter of last year. That rebound in economic growth defied economists' expectations of a recession.

This was due to the enormous avalanche of monetary support coming from government spending programs. However, that monetary impulse is now being reversed.M2 as a percentage of GDP growth

As far as the “reflation trade” As far as the economy is concerned, as that monetary impulse recedes, so will economic growth, as shown. Even if the economy continues to grow at an annualized 2 to 2.5% each quarter, the annual rate of change in growth will continue to slow.

Actual and projected GDP growth rates

It is important to highlight that this assumes that the Government will maintain “Spend like drunken sailors” during that same period. However, if they do not do so, the rate of economic growth will slow even more rapidly without increasing monetary spending.Debt issuance is required to cover the expense

It is important to remember that increasing debts and deficits do not lead to stronger economic growth in the long term. As debt levels rise, economic growth rates will slow as money is diverted from productive investment toward debt service.GDP Debt to GDP Growth Ratio

This reality should not be surprising, since it is not the first time that the Government has gone “all in” in a reflation operation. As noted above, after the financial crisis, the government intervened with HAMP, HARP, TARP, and a host of other spending programs to “reinflate” the economy.

Let's review what happened to interest rates, inflation, and the trade of gold and commodities.

The past can be prologue

As noted in 2009, after the “Financial crisis” and recession, the Government and the Federal Reserve adopted various monetary and fiscal support measures to repair the economy.

While the economy initially recovered from recession lows, inflation, economic growth and interest rates remained subdued despite ongoing interventions.

Interest Rates: GDP and Inflation

This is because debt and artificially low interest rates lead to bad investments, which act as a wealth transfer mechanism from the middle class to the rich.

However, such activity erodes economic activity, leading to contained inflation and a .

Inflation-adjusted household capital ownership by tranches

During that same period, commodities and precious metals initially rose as “reflation expectation” It was very widespread.

However, debt-driven realities quickly undermined that assessment, and those investments languished compared to stocks as the flood of liquidity and low rates made stocks much more attractive for investment.

S&P 500 vs. Gold vs. Commodities

While the relative performance of precious metals and commodities has rebounded in recent months, this is more likely a function of “irrational exuberance” in financial markets.

As discussed above, increased speculative investment activity is not uncommon in the markets and many asset classes are currently becoming highly correlated.

However, while there is a compelling narrative around gold and precious metals from an investment perspective, those who pursue that trade have had many years of horribly poor results.

While this time might be different, the “reflation narrative They will most likely fall prey to the reality of excessive borrowing, which will pressure governments to cut rates once again.

If the past is potentially prologue, the bullish narrative of “reflation” You may encounter disappointment again in the future. This is particularly the case as debt economics and poor policy decisions continue to further erode the middle class.

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