Everyone Is Crowding Into Reflation Trades Priced for Perfection

(Bloomberg) -- With reflation trades notching some of their biggest gains in decades, even stock bulls can be forgiven for fearing that global markets are priced for perfection and risk sinking next year.

Small-cap stocks in the Russell 2000 that do well as growth rebounds have earned almost 30% so far this quarter. Emerging-market carry trades are on course for their biggest quarterly gain since 2012. A gauge of global value stocks that tend to ride the economic cycle has just had its best month since 1975.

At this rate, the bar is high for the fourth quarter’s blistering trades to outperform in 2021, warns JPMorgan Chase & Co.’s Nikolaos Panigirtzoglou. Setbacks in the vaccine roll-out or wider lockdowns could create big market disappointments in the months ahead.

“Given how optimistic the consensus is at the moment -- effectively looking for normalization of economic life by next summer -- I would say the risk balance is skewed towards the current consensus proving too optimistic rather than too pessimistic,” the global strategist said in an interview. “Reflation is consensus, and it only has juice if next year it plays out better than the consensus envisages at the moment.”

Here’s a gutcheck on those V-shaped recovery trades.

Equities

Small-cap shares have made explosive gains as the prospect of millions of people leaving from lockdown spurred bets on a broad pickup in economic growth. One milestone was the Russell 2000 index recording its best month on record during November on its way to a 27.5% total return this quarter.

Still, anyone betting against growth stocks that tend to be less tied to the economic cycle are in dangerous territory. The Nasdaq 100 generated a 10.8% gain including dividends during the same period, fueled by the work-from-home shift.

Currencies

Buying a basket of emerging-market currencies with the dollar earned 6.4%, the best quarterly gain on the strategy since 2012, according to a Bloomberg currency index that measures carry-trade returns funded by short positions in the greenback.

As market fears eased after the March sell-off, demand for the U.S. dollar has also faded -- in turn helping commodity prices to rally and lifting currencies in emerging markets to the highest since April 2018.

Investment banks are touting overweight positions across most developing-economy assets going into 2021. Nomura Holdings Inc., for one, suggests investors short the dollar against Chinese yuan, Korean won and Indian rupee.

Commodities

With the global industrial cycle starting to recover, copper is in the midst of a historic rally with prices soaring at a speed rarely witnessed since the supercycle boom of the 2000s. The metal has vaulted to the highest in seven years, supported by China’s economic engine and a global move toward low-carbon power sources.

Citigroup Inc.’s analysts led by Ed Morse have said the metal is “too hot to handle” and prices may retrace. A rally of about 15% since the end of October has pushed copper’s 14-day relative strength index above the 70 level, a signal to some investors that a pullback could be ahead.

Bonds

Fixed income markets have been resilient regardless of the reflation narrative taking hold, extended gains since the March turmoil amid speculation that central banks will double down on asset purchases.

While the reflation trade may have some legs through the first quarter, “what matters to bonds today is the debt overhang, made even worse by the pandemic, and central banks committing to keep rates low for a very long time,” Steven Major, global head of fixed income research at HSBC Plc, wrote in a note on Wednesday. “We expect core rates yields to be trapped in a range for years to come.”

A gauge of global bonds with maturities over ten years generated a total return of 3.1% quarter-to-date, slightly ahead of a 2% gain during the same period for counterparts which mature within the next three years.

Bulls are on shaky ground from here, with Morgan Stanley projecting the economic expansion will push 10-year Treasury yields to 1.45% by the end of next year from 94 basis points currently. And some sections of the curve show firmer signs of growth ahead, with the spread between 5-year and 30-year bond yields near the highest in four years.

Breakevens

And some market-based measures of inflation expectations, such as breakeven rates and inflation swaps, are showing a quicker pace of price growth. Treasury Inflation Protected Securities have gained 0.8% so far in the fourth quarter, according to a Bloomberg Barclays gauge.

The price growth foreseen in the years ahead comfortably exceeds the current nominal yield on Treasuries -- suggesting an inflation surprise could haunt bond bulls in 2021.

©2020 Bloomberg L.P.