The reflation trade that began last August has paused. Markets are catching their breath. After reaching a YTD high of 1.74%, the 10-year Treasury yield settled back to 1.58%, falling 10 basis points since Tuesday's inflation report. The yield curve (2y10y) flipped to a flattener from a steepener, the first such signal since March 2020. Inflation expectations five years out are consolidating around 2.5%. Commodities outperformed stocks by +7% YTD but underperformed -1% MTD. A basket of equal-weighted inflation beneficiaries (industrials, materials, energy, and financials) outperformed the S&P 500 Index 18% YTD but underperformed -3% MTD.
The pause is nothing nefarious, in our opinion. The stronger U.S. dollar (+3% in 1Q) acts as an inflation offset. Next, a weakening China credit impulse suggests new lending has a less positive impact on China's economic growth. Indeed, the world's second-largest economy continues to report disappointing economic and inflation data. Also, market narratives pivoted from re-opening optimism to uncertainty surrounding COVID-19 variants and vaccine hesitancy. Other uncertainties include fiscal policy headwinds in 2022 and how taxpayers will pay for historical levels of stimulus. In the words of Strategas' Dan Clifton, "every good party needs to come to an end, and the fiscal stimulus party over the last 15 months will slow down starting in the second half of 2020."
RiskBridge does not subscribe to the out-of-control/hyperinflation view. However, we expect more inflation and a resumption of the reflation trade through 3Q due to base effects, global supply chain disruptions, and temporary labor shortages. Our analysis points to U.S. headline CPI potentially approaching 4%. Historically, during episodes of reflation, stocks outperform credit, which beats rates. We believe U.S. stocks can continue to outperform, but with an important caveat: a sustained CPI above 4.0% would become a significant headwind for equity multiples.
We are fully invested with tactical equity tilts toward dividend growers, large-cap value, energy, and financials. We have a bias towards developed international markets where valuations are less stretched than the U.S. We recently added REITS to our portfolios and remain overweight commodities and private market opportunities (growth and income). We prefer high yield credit and emerging market debt in fixed income and are underweight Treasurys and spread product. We continue to avoid TIPS as we believe the adverse duration effects of rising nominal bond yields will more than offset the positive impact of rising inflation premiums. Finally, municipal bonds are rich, but we think they are of great importance for taxable portfolios as Congress finds ways for us to pay for the most extraordinary stimulus program in peace-time history.
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