The Reflation Trade
Featuring Michael Gayed
Published on: July 1st, 2019 • Duration: 12 minutesMichael Gayed, CFA, portfolio manager at Pension Partners & author of the Lead-Lag Report, highlights the current dynamic playing out between the stock market, the Fed, and inflation expectations. In this interview with Jake Merl, Gayed revisits the bullish thesis on emerging markets as the dollar continues to weaken — a thesis he also outlines in an upcoming note on Real Vision’s Think Tank product. Gayed then discusses why certain sectors such as financials should outperform in a reflationary environment. Filmed on June 27, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down Michael Gayed, portfolio manager at Pension Partners and author of the Lead-Lag Report. Michael, great to have you back on the show.
MICHAEL GAYED: Always a pleasure.
JAKE MERL: So, you've been here several different times over the past few months talking about the probabilities of a spring crash for stocks. Now, that thesis didn't quite play out as the Fed stepped in with this dovish pivot. And you were just here a few weeks ago talking about how emerging markets should outperform the S&P in this easy money environment as the dollar weakens. So, what exactly are you looking at now?
MICHAEL GAYED: Yeah, so look, it's clear that central bank paranoia is in full swing. It's not just happening with the Fed, it really was sparked by the ECB last week. And it seems like there's this very serious worry that the direction of inflation expectations has to be reversed. And a lot of the argument I was making around a potential spring crash or big collapse really related to a potential liquidity scare, which it seems the central banks now are trying to get ahead of. They're obviously seeing something, something clearly was ridiculously wrong to the fact that they are now reversing course so aggressively.
Now, this is a debate about inflation and deflation. And in terms of timeframe, whether you're able to get inflation expectation to pick up near term versus very long term. Couple things to think through here. One is the Fed likely is going to do something, likely they're going to cut rates, likely the ECB is going to take on further action, because at this point, they're going to have to. The argument is that that's a form of insurance just in case things get worse in the trade war from of course, is that at least historically, when the Fed has cut two times in a row, that's precedes a recession.
Doesn't have to be the case. I believe historically, the odds are not good for the economy if that's the sort of messaging the Fed wants to put out there. The issue for the Fed is nothing they've done clearly has caused inflation expectations to sustainably pick up or sustainably rise in any way. I think a lot of that has to do with oil. Historically, oil tends to be the best correlated commodity to inflation expectations. As market participants look at oil day to day, they view that as a source of cost push inflation, that should cause inflation expectations to rise, which should then prevent the Fed having to lower rates to try to spark inflation.
And that is consistent with emerging markets rallying, with commodities in general rallying. I think for the Fed to ultimately get this right and the ECB to get it right, they need commodities to help them push through an expectation of rising prices, which should cause an increase in the cost of money, which also ultimately increases inflation. That has a lot of implications on various sectors of the stock market. The main one really being financials. A lot of people talk about the disconnect between the value and growth style, that you've had this incredible outperformance of growth as a style versus value, not really taking into consideration that the reason that value has underperformed so much is because the largest sector of most value indices is financials.
Financials have had a very hard time largely because they can't really make money when the yield curve is doing what it's doing. In terms of lending long and borrowing short. If you're going to bet that the Fed commodities at reflation is coming from a sector basis, financials make a lot of sense. If you're betting on a global basis, emerging markets, commodities make a lot of sense. But all this is short term, I still maintain that long term, deflation is probably more likely than none in our future.
JAKE MERL: So, isn't the Fed cutting rates almost a deflationary signal?
MICHAEL GAYED: Yeah, so this is an interesting thing to think through. If central banks are getting market participants used to the idea that they're always going to save the system with lower rates, and market participants always believed the system always needs to be saved, then you never really have the urgency to borrow. Because rates will always be lower at some point in the next year, two years, three years. So, if everyone believes that, how can you possibly have a pickup in the increase of transactions to pick up in the velocity of money?
So perversely, I think if the Fed continues on this path of trying to save the economy, save the markets by always lowering rates rather than just staying put, you may actually have the opposite effect. They may actually be the reason why inflation expectations continue to go lower. Because the idea is that they'll just keep on lowering no matter what.
JAKE MERL: And so historically, when you look back, when the Fed initially cuts rates, the stock market initially rises. But that marks the top of the market, and then we get the recession and the bear market. Do you think that will play out the same this time?
MICHAEL GAYED: I still think that with hindsight, I think we had a global bear market start end of January 2018. I think we actually have been in a bear market. And that's the thing about bear markets, you don't know you're in one until long after it's probably over. And remember, you can have bear markets without recessions. This is so many people forget in a conversation. A lot of global equities peaks in late January of 2018, small caps have not made new highs. In the US, we've got a lag quite a bit as well. A lot of commodities have not really come back.
So, it could really be that this has already been in play for some time. We haven't seen a capitulation move and you haven't seen it in the S&P, which still is the only place to be as it has been for several years now. The thing is, if you're going to say there's going to be a bear market here, you're inherently then saying something really, really is off because you've had- if you're going to have a global bear market starting right now and then the S&P starts correcting, emerging markets still have been crushed already. The commodities have already been crushed. A lot of things have already low prices. So yeah, they can go lower. But at some point, you've got to probably bet that maybe there already is an overreaction in that disinflation trade near term.
JAKE MERL: So, before you mentioned financials, commodities, how exactly would you go about playing the current environment?
MICHAEL GAYED: So, I think from a sector basis, energy financials probably make the most sense. I know people still love tech and tech still has momentum. At some point, that will change. The thing with momentum, a lot of interest stays on the momentum factor, momentum works but when it turns, it's like a multi-standard deviation event on the downside. So, I think that makes a lot more sense now.
The defensive sectors I think are likely to sell off further. Utilities, which had been abnormally strong look like they're probably on the verge of really weakening quite a bit. They're also overvalued from a fundamental basis. Healthcare might buck that trend only because they've already taken it on the chin quite a bit. Energy financials, again, make the most sense. Commodities, we've seen quite a move in gold. And I think that's probably likely to continue. I've had this long standing argument that the last great bubble is faith in central banks to solve all problems, that the feed system ultimately leads to tremendous debt over the long term. Democracies ultimately lead to tremendous debt because politicians have to always promise new and better things and that means taking on more money, borrowing more money. At some point, you'd get to some saturation debt levels, and maybe then the market says, well, there's something to gold standard, maybe there's something to discipline that comes with the yellow metal, and maybe that we're starting to see some of that reasoning play out. Same thing maybe with Bitcoin. That's probably one of the same thesis here.
So, I think broadly speaking, commodities make a lot of sense. And again, I go back to a lot of what I think is happening here really does relate to the dollar. The dollar has sold off the last couple of weeks. I expect that to continue. I think at the end of the day, that matters more than anything else. The dollar weakens, dollar's going to make an asset trail, inflation expectations rise, Fed won't need to cut and that probably does give more credence to the idea of a reflation trade to come.
JAKE MERL: So, as this reflation trade unfolds and the dollar weakens, you're also looking at emerging markets as well. Is that right?
MICHAEL GAYED: Yeah, look, I know there's still a lot of talk around China and whether something's going to happen or not. I suspect that Trump's reelection matters more than a trade deal. And what I mean by that is, if a lot of the reason why he might get reelected is because of the economy and the stock market, he's got every incentive to keep pushing that higher. And in some ways, it's the best timing because if you're going to do it, you want to do it towards the tail end of a pre-election year, so that you have something to hang on, you hang your hat on during the election. So, I suspect that that's going to get done fairly quickly. And that may be why China itself is starting to rally too.
JAKE MERL: So, China is a huge part of that EEM, ETF. Does that worry you at all?
MICHAEL GAYED: No, I like it. Look, this is where all the bearishness has been. And, look, there's a lot of politics, a lot of theater when it comes to this stuff. We saw the theater with Mexico. And that was the same week that you had that poor jobs report, as I recall. And it only took five days or whatever it was for Trump to say, oh, we made a deal. Nobody really knows what the deal was. But all those concerns around Mexico very quickly went away because it was concerned about how it impacts the markets.
This is a higher stakes game with China. But I think you're going to come to some agreement and whatever the agreement is, whether it's good or bad for the US or for China, it won't matter. It'll catch a lot of people offsides if it does happen, and potentially cause a rush to Chinese stocks.
JAKE MERL: So how much upside do you actually see for emerging markets, commodities and financials?
MICHAEL GAYED: Yeah, so look, I think I mentioned before in the few weeks ago that emerging markets, when they run, they run 2000, 3000 basis points over the S&P pretty quickly. You can have this convergence trade. I think that's still obviously very much in play. I think financials have substantial performance potential if the reflation trade plays out. But again, all this is short term, I want to reemphasize this, I think very long term, there's still some very serious problems. The yields have not really risen just yet. So, all this is pursuant to the idea that yields actually react the way they should in a reflationary environment. If they don't, that to me is a much bigger problem.
And again, I go back to you don't really know which scenario plays out. Are the bond markets right or it's going to be wrong because the central bank's going to force it to be wrong? If that's the case, substantial outperformance and everything outside of the S&P. The S&P to me is the last general that you don't want to bet on. It's old, it's tired. It's worked phenomenally. But if you're a believer in buy low, sell high, I don't know why you would want to touch large caps here.
JAKE MERL: So, Michael, when you say short term for this reflation trade, what do you mean exactly by that?
MICHAEL GAYED: So, I think you're talking the next three or six months that you're going to have some reflation trade, or at least let's call oversold disinflation balance. I'm saying that because if the yield curve inversion ends up being correct that the recession is coming, it's hard to see a recession with inflationary pressures, given the way things have played out. So, you really only talked about maybe three to six months out. If the yield curve was wrong, it could be much longer than that. If the yield curve is rights and you have a recession in the election, during the election year, then a lot of those oversold bounces start resuming downward.
JAKE MERL: Well, Michael, that was great. We'll see how it plays out in the months to come. Thanks so much for joining us.
MICHAEL GAYED: Sure, Jake.
JAKE MERL: So, Michael is bullish on emerging markets. Specifically, he likes buying the iShares MSCI emerging markets ETF ticker symbol EEM to S&P 500 ratio at current levels. He sees 20 to 30% upside potential over the next three to six months. He also likes buying financials and commodities as a way to play the reflation trade. That was Michael Gayed of Pension Partners and for Real Vision, I'm Jake Merl.