The equity market is all about the bond market. If there’s one thing I’ve learned in 23 years running money in equities and derivatives, it’s that the bond market is always early and correct, relatively speaking. I don’t think I actually learned it until 2008. I remember clearly, running a long short fund watching equity CDS blow out in Australia. I remember having conversations with people wondering what’s going on there, but not really appreciating the significance, that something really potentially quite serious was going on. I remember CDS in RIO blew out to over 1000 basis points. This is something that should normally trade between 25 to 75 points Rarely do you see a move like that, maybe once in your career. When you see numbers on the screen that you just couldn’t have ever imagined beforehand, sit up.
Today the bond market is telling us something again. A year ago, I started talking about inflation. Mostly actually off the back of the expectation of fiscal stimulus that may come because of COVID-19. We’ve sat here for 10 years watching QE increase central bank balance sheets. We have all become resigned to the fact that there won’t be any inflation because there wasn’t any. Really all QE was doing was sitting on bank balance sheets and increasing Tier 1 ratios to keep regulators happy. The narrative, a couple of years ago changed to well, if we ever get some fiscal, we could get some serious inflation. So, when COVID-19 started. I’m thinking maybe this is it, maybe this is inflation, maybe I’m just hoping because I’m a value investor and value investors do better when rates are higher. Now though there’s actual growth in the economy. Anyway, the first and most important sign was back in October 2020 when inflation expectations really started to rally. Remember, earlier in 2019 break evens went negative, i.e. the expectation that in the future inflation would be less than zero? So, when they turned and started to rally it looked like an amazing set up and started to get value investors excited. Certainly, I was. Anyway, fast forward to now, and inflation is the only thing that people want to talk about.
We’ve seen the beginning of the ‘great rotation’ as I’m going to call this move. So, we’re seeing the great rotation start, which is the return of value over growth. Having never been able to coin a phrase, I’m hoping this one might catch on. I always thought ‘Minsky moment’ was a great catch phrase. ‘The great rotation’. 2021, the beginning of a value dominance rotation that can last multiple years. You see, this time fiscal is essentially pushing the bond markets inflation expectations. That’s what’s really driving this rotation into value. What we’re seeing now is actual growth in economies, massive GDP forecasts. And that’s really the next leg of the story. Can this growth, turn into a tighter labour market, which will push wages up, which will invariably cement the inflation thesis in place? As a side discussion, is the Phillips Curve broken? That’s important. The relationship between inflation and unemployment has broken down over the last few decades. It worked in the 1960’s (this narrative kind of sounds like 60/40 portfolio construction!). In fact, the R squared on that relationship is almost zero and has been for quite a long time.
We’re seeing anecdotal inflationary pressures in the market across multiple sectors. Freight, manufacturing costs, supply chain. It’s coming from everywhere, in the most recent quarterly updates from the US company reporting season and now with that quarterly reporting season on again, it’ll be interesting to see the rate of change in that narrative from last quarter to this quarter.
So, I’m an equity investor and I spend a large chunk of my time watching the bond market. Go figure.
