Join Adam Hetts, Global Head of Portfolio Construction and Strategy, as he speaks with Co-Heads of Strategic Fixed Income Jenna Barnard and John Pattullo about whether there is substance to the reflation trade.

Key Takeaways

• The consensus trade expects inflation, but much of this may already be priced in, creating potential opportunities in medium-term bond yields if inflation proves transitory.
• An excess of private savings before COVID-19 required governments to spend to balance private-sector saving. In some ways, today’s fiscal stimulus is an extension of the response to the deleveraging environment that lingered after the Global Financial Crisis.
• For reflation to be convincing, we need to see evidence that households and businesses are changing their behavior toward taking on more debt – yet credit demand remains soft and markets seem to be ignoring weaker data in China.

View Transcript

Adam Hetts: Today on Global Perspectives we have another check in with Jenna Barnard and John Pattullo, our Co-Heads of Strategic Fixed Income. I’m excited for this because you’re going to hear that John and Jenna have a very high-conviction view that is going against consensus right now. And for those of you that have followed them over the years, their scorn is going to sound familiar from the time before COVID where they were long interest rates and the rest of the market seemed terrified of duration and short interest rates. Of course, they were right about that way before the rest of the market figured it out. And here we are on February 12, the U.S. 10-year [Treasury yield] is about 119 [basis points (bps)] today and a lot of the government bond market seems back to 2019 levels. So, this time, it’s about the reflation trade. John and Jenna are looking at the market consensus on the reflation trade and saying the market is wrong once again.

Okay then Jenna, this reflation trade, which we’re seeing everywhere, it’s short duration, short the dollar, long emerging markets, long commodities, long credit – what evidence do you have that we’re closer to the end of this than the beginning?

Jenna Barnard: Hi, Adam. Well, we look at valuations. We try and decompose the 10-year yields and the 30-year bond yields in the U.S. And before I start, it’s worth saying that this reflation trade has only really affected a handful of government bond markets in developed worlds. You know, the U.S., Canada, Australia and New Zealand, and very modestly in Europe and the UK. But when we look at what’s going on underneath the surface of the bond market, we actually think that quite a lot has been priced in, in terms of the cyclical inflation outlook. I mean, you can, most obvious starting point is always break evens. So that’s the 10-year inflation expectations within the nominal bond yields. And that’s reaching levels, actually, I think higher than where we got in 2018 at the peak of the last cycle. So, we’re over 2.2% for 10-year inflation expectations going forward. And the nominal bond yield that everyone looks at on their screen, which is yielding, as you said about 1.2%, is being weighed down by negative real yields, okay, and which is very much what the central bank has kind of dictated and created. So, I think inflation expectations themselves are right up there at kind of cyclical high levels. And if you look at, you know, a proxy for where the market thinks interest rates may peak, what level interest rates might peak once they eventually do start rising, we use a measure called the five-year, five-year forward. So, what’s the five-year yield starting in five years’ time? That’s a bit, you have to bear with me, it’s a little bit bond geeky, but that again at about 2%, you know, that’s getting up to very interesting levels. U.S. rates obviously peaked around 2% to 2.5% in the last cycle, and so, we, from my perspective, both of those elements are getting back to what you would think of as normal kind of valuation points.

If you take the 30-year yield, which has borne the brunt of the repricing in the U.S. at 2%, again that’s getting back to 2019 levels. So, really, you know, it’s the front end of the curve out to five years, which hasn’t repriced because the Fed [Federal Reserve] is so adamant that they’re not going to raise rates until the very bottom end of the labor market improves. And a recent speech by a Fed governor pointed out that the bottom quartile of wage earners in the U.S. have an over 20% unemployment rate. And that’s what the Fed is solving for. It’s not the top quartile of wage earners, whether it’s 5% unemployment; it’s the bottom quartile So, you know, unless you think the Fed is going to raise rates much quicker, I think primarily because the unemployment situation gets much better, then we actually think quite a lot has been priced in. And we’ve come from, you know, really suppressed levels of valuation last summer when we did actually get short duration. We thought those valuations were wrong. So, levels which we think are quite peaky, quite perky are really quite interesting. So, I think that’s always, you know, valuation’s always a good anchor. And then John and I overlay that with, you know, sentiment positioning, lots of other measures to just give a sense of how this narrative is washing through markets and when the market might be getting over its skis. From that perspective, the indications that we look at also are definitely in the zone that this reflation narrative is becoming essentially a momentum trade. It’s becoming slightly mindless at this point, I would say. Having been, you know, justified in cheap trade last summer, it’s very over-positioned and I think, as I say, it’s becoming slightly more momentum driven than anything else.

Hetts: So, a few things to unpack there. I guess, first a quick one: You mentioned the five-year, five-year forward, so that’s new to me. Usually I hear about, it’s the 10-year as a proxy for market consensus on rates, then the two-year for the consensus views on policy rates. So, with a five-year being in the middle – you said the five-year, five-year forward is around 2% – where is the five-year today? And then do you view this as a mix of policy and market views or is this more of a proxy for policy expectations?

Barnard: So yes, so the five-year yield in the U.S. is about 48 basis points today, so it’s barely moved. We’ve actually always used the five-year, five-year forward, Adam. I think we maybe just because we’re in the kind of guts of the bond market, but we’ve always used it as a proxy for where the market thinks long-term rates and therefore kind of long-term growth and inflation might peak out. I remember even we were using it back in 2016 during that sell-off. So, I don’t think it’s new for us, maybe it’s a more saturated move because the market just can’t … there’s been a lot of steepening of the yield curve because the market can’t price in the Fed moving yet at the front end. But it’s certainly a measure that we’ve always followed with great interest. Because really, you know, what is, what are long bond yields about? They’re about long-term growth and inflation. They’re not about whether we get, we will go out on holiday and to restaurants this summer. You know, we’re going to get that pop. Everyone knows about that pop. And we’re going to get base effects driving inflation. We don’t think of it as inflation. We think of it as price volatility. But once we’re through that, the bond market is really all about, you know, the long-term potential of the economy.

Hetts: Thanks, that’s helpful. And the other thing that stuck out, you said it’s a mindless kind of momentum following of this reflation trade at this point from your view. And you say mindless, I think about the mind-boggling amount of fiscal stimulus out there that’s just pushing a lot of people into these kind of risk-on trades. So, maybe we should talk a bit about what you view as the long-run growth effects of all this unprecedented stimulus and how that plays into this reflation trade and just how you see that affecting the economy across different sectors.

Barnard: We definitely can. But before we do that, I’ll just say the reason I’m saying I think it’s mindless at the moment is that it’s taken as given. It’s taken as given that 10-year yields are going to 150, 170 [bps]. It’s taken as a given that you’d be mad to buy a government bond and that you have to buy anything in the bond market that doesn’t price (inaudible) – high-yield credit, subordinated financials, floating rate loans. You can just see the wholesalers with their suitcases out and what they’re offering. And it’s at that point where it’s assumed and it’s taken as a given that duration – it’s going to sell off, government bond yields are going to rise. But silly things happen. People buy other parts of the bond market not because they like the valuations there – I think it’s actually quite hard to make a really bullish case for credit at these valuations – but simply because they want to hide from that perceived threat of government bonds. And that’s very, very similar to Q4 2018, really similar. And that’s where it starts to get a bit a bit worrying. And, you know, we’re not saying that it peaks out today or tomorrow. I think we’re in the zone. It may last with these base effects to kind of March, April, May. But at this point, I do think it’s mindless and there will be mistakes made on the back of it.

Hetts: Yes, you mentioned 2018, and I would just say, you know, this isn’t the first time you’ve been way against consensus. Like you mentioned 2018, there’s some really big names calling for higher rates and higher inflation and you are against that. Like is this uncomfortable for you two? Or how does it feel going against the market?

Barnard: I’m very comfortable being a contrarian and kind of actively embrace these reflation trades as an opportunity to get long duration every couple of years. And I look forward to them, I find them exciting. I enjoy, you know, enjoy people telling me that this is the end of the bond bull market, etc. But I have to say it feels really, yes, it was really uncomfortable in meetings. And I think people almost don’t know how to respond if you say you like 10-year bond yields at these levels, there’s just people kind of are shocked, I think. Their jaws drop and they kind of think we’re a bit crazy. Really, I’ve really noticed that in the last week or two.

John Pattullo: We have been ridiculed before, Adam, over the years, especially for Japanification of the global bond markets over the years. So secretly, I guess, we kind of like it, but, yes, it’s a little bit angsty, of course it is. But it’s just sometimes when, you know, strategists come in and say, “Because bond yields are going to rise, you have to do this,” or, you know, I was even watching an investment seminar of some of our competition say, “When bond yields rise, we’ll be fine because we’re short duration.” And Jen and I kind of love this sort of, you know, consensual narrative. It’s just, we actually so especially and to be honest, when it’s quite high profile, very rich, billionaire type people come on CNBC and tell us that there’s going to be loads of inflation and it’s all going to be a disaster, we have to sell all our bonds, it slightly engages us, doesn’t it, Jen? Especially, you know, quite respected or, you know, high-profile people. And, you know, some of those high-profile people called rates horrendously wrong in 2018 when, you know, people said rates are going to 3%, 4%, 5% and rather famously 6%. You know, and that’s when real yields back then actually went from roughly 0.5% up to 1.2% and the Fed was sort of slamming on the brakes. And everyone says, “Well hang on, you know 10-year’s going to go to 4% or 5%.” It’s gone nuts. But the skill and I suppose the angst I suppose is, are we the most stupid people in the room? Well, hopefully not. But also, it’s more of the scaling of the positioning and living through it and not going too much too early, if that makes sense. That’s the hard bit that Jen and I have to kind of live through and support each other accordingly, I think.

Barnard: Yes, I think that’s a really good point because our industry has a terrible track record with reflation trades. We did a little Google Trends you know, graph of reflation trades and they come around every other January. And our industry is very good at pumping them up and very bad at knowing when to take them off, yes, and when to fade them. And yes, they jumped right. The question in our mind really this year has been more how to average in situation. Yes, it’s not … I don’t think we feel particularly challenged by this refreshed narrative and we’ll come on to that in a moment. It’s really more about, obviously, the timing, the positioning, the base effects coming this spring. And that’s, really, I think, more the art that we’re, that we struggle with on a day-to-day basis.

Pattullo: And again, it slightly speaks back to the sort of traditional economic analysis that says you’re going to get a reflation trade and you got to do this and that. And one of my, our equity colleagues, Peter actually, it’s almost like I don’t know if you agree, Adam, but there’s the sell side. So, the investment banks are almost pumping this a bit harder than you know, us, the fund management side. So that you know, that’s sort of conventional orthodox economics. Well, you know, things have changed quite a bit here. You know, and I guess Jen and I are quite dismissive of conventional economics. And dare I say, some of the sell-side strategists are a little bit orthodox and conventional because, you know, they write 100 pages on this stuff and frankly, that’s all fairly obvious. But markers aren’t off, they look ahead, as well.

Hetts: Yes, I think there’s definitely a long bias in the industry, and you’re hitting on something with the bias and viewing interest rates in that. And in my team and the portfolio construction consultations we do on fixed income going back nearly a decade now in the U.S., rates got below 3%, they got below 2%. So, it was exactly that kind of reaction was, “I’m short duration so that I’m prepared when rates rise.” But you compare the analog to the equity mentality, nobody was saying, “I’m short tech because P/Es [price-to-earnings ratios] are at 20. So, I’m short for when P/Es go down.” It’s a whole different interpretation and a relative valuation, you know, and room for unprecedented outcomes. But that doesn’t translate to fixed income for some reason. They just expect rates to snap higher regardless of the global environment sometimes.

Barnard: Yes, now that’s all about the mental framing. That’s why we come into it like, “Okay, let these refreshing narratives run.” You know, and that’s the opportunity. That is the opportunity as a bond investor. But obviously, as you say, everyone perceives it as a risk. Actually, Adam, that brings me to, I was going to ask you, how do you think, when you look across advisors’ portfolios, how do you think positioning is currently within fixed income? And how do you think it’s moved in the last year or so?

Hetts: It has moved some but the anchoring point before that was because of all this fear and terror of rising interest rates for nearly a decade, one of the things that we track is we’ve got thousands of U.S. advisor portfolios in our U.S. database. And the average fixed income portfolio, only about half of it was closer to the benchmark. You know, core, core plus, duration investment-grade type strategies, and the other half had moved into non-investment grade, more aggressive equity-like fixed income. So it was a constant conversation point with us and our clients was that, “Yes, you’ve made more money with this so far, but at the end of the day, you need your bonds to feel like bonds especially when you need them to feel like bonds.” So what we’ve seen since COVID was a little bit of a reminder of the downside protection you want out of your fixed income portfolio and that average has drifted from call it 50/50, you know, traditional versus non-traditional to being about two-thirds traditional core and about a third more non-traditional equity-like fixed income. So, it’s gotten more conservative relative to the starting point. But in our view, these are still pretty aggressive fixed income portfolios on the whole.

But you mentioned looking at Google Trends and by coincidence, I looked at that in preparation for this, I looked at inflation versus reflation, and inflation hits are near all-time highs and reflation is barely moving on Google Trends. So, I guess we should talk about semantics for a second, with everybody talking about inflation, but we’re going on about reflation. Inflation is such a broad term, so how do you define or differentiate the two, inflation versus reflation?

Pattullo: Let me take that and I’ll try and be brief.  I think people are a little bit loose in what … It’s a very common question we get is, “Well what about inflation?” I kind of go, “Well, what sort of inflation are we talking about?” And I think there’s lots of, so there’s wage, there’s asset prices, there’s cost push, there’s demand pull, there’s, you know, there’s endless types of inflation. But I think what people really worry about is a persistent demand pull-led – too much demand, not enough supply in the economy, pulling up prices of goods and that then moves on to pulling up wages – and you get you know, an inflation spike as you did in the ‘70s and the ‘80s. And I think I would define that as structural demand-pull inflation because we have an output gap. And the Fed wants to close the output gap and rightly so to employ more people and so on. Our opinion, and that would be persistent inflation I would call that and structural. I think what’s … and we don’t see that really happening at all. And if it’s going to happen, it’s so far away that, you know, we can’t forecast that.

What we do expect in the very short term into April or May is quite a high spike in CPI  [Consumer Price Index], be it headline or core, primarily because the old price actually fell negative last March/April and mathematically because of base effects, when those numbers jump out, you get a spike-up in inflation. And that is bottleneck inflation really driven by the oil price and, you know, there’s bottlenecks currently in copper, iron ore, lumber, shipping, semiconductors and, of course, the oil price. And that is transitory, and even the Fed has got the hang that this is transitory and they shouldn’t react to it. So, you know, they should not, there shouldn’t be a reaction function to this transitory spike-up due to short-term bottlenecks in inflation.

And for what it’s worth from the work we’d done, we actually think inflation could then fade quite rapidly into the back end of the year. And everyone saying, you know, “Where did all that inflation go?” And I think the other point, Adam, is this is bad inflation. It’s like tax inflation, you know. So, the oil price goes up, it costs you more to fill up your car. That’s bad inflation. That’s tax inflation, and that’s a negative and certainly shouldn’t be confused with a breakout with inflation and inflation expectations.

Now the Fed is kind of on this and they’re lost and they’re now calling it transitory. And hopefully, they won’t react to it. They said they won’t so they certainly shouldn’t. But I think some people are just a little bit loose in how they define this stuff and should bear that in mind. We think this is a great opportunity because we’re not worried about inflation. We’re worried about other people worrying about inflation, if you’re with me. And that’s the opportunity because people obviously are short of bonds, want to sell bonds because they think it’s going to be persistent. And we think it’s going to be short term and transitory. And that’s the kind of interesting bit for us.

Longer term, we don’t really think there’s much of an inflation problem at all. I mean there’s various composition effects going on because, obviously, we’ve all bought goods and not bought many services and that’s got to switch back. American inflation actually is broadly the same as European inflation. It’s just they have different constituents in the base as well. So broadly speaking in Europe, they don’t cover owners’ equivalent rent or shelter costs as they do in America. So, to say that Europe has structurally lower inflation compared to America is actually not really right. It’s a little bit right, but not really.

So, you know, all we see is excess capacity and bottlenecks, not to be confused with genuine excess capacity. You know, airline, shipping, steel, autos – there’s plenty of capacity out there. It’s just when we all go back eventually, hopefully we will, you know, there’s not going to be enough oil or, you know, seats on the planes for a while. But that isn’t a breakout of inflation or inflation expectations.

Hetts: I think that’s a great framework for the listeners to keep in mind. I can try to maybe clarify that or maybe simplify it. So, there are structural, like long-term persistent inflation versus cyclical, which would be short-term, not long-lasting inflation. And then different types of good and bad inflations – that cost push would be the bad inflation where it just, costs are going up and things like oil. And that might be where we get some near-term cyclical inflation from some prices going up in the short run, which will make inflation headlines. But maybe that would be interpreted as cyclical, bad types of inflation. But it doesn’t matter as much that it’s bad because it’s only cyclical. But then what you want as far as the good part of inflation would be that demand-driven inflation from wages going up more, money in the system, pushing prices up because everybody has more money to use to push prices up. And having that good inflation structurally is something to be optimistic about. But I think to your point, we’re a whiles off from that. Is that a fair summary?

Barnard: Okay, the one thing I would add to that is that coming out of a recession, we always get this kind of base effect, commodity-driven inflation. We had it in 2010-2011. U.S. headline CPI got to 4%. UK headline CPI got to 5%. And even in Europe, you had headline inflation at 3% or above. And the ECB [European Central Bank] hiked twice. They hiked twice. And four other central banks in the developed world hiked, yet all small. And that was a formative experience for central banks. You know, decomposing what is good and what is bad inflation. And frankly, this one looks modest in comparison. You’re going to get U.S. headline inflation to 3% for a couple of months, then back down to 2% or below. Frankly, the bond investor, this one is not particularly frightening and it’s very normal coming out of a recession. I think people really buy that decomposing the cyclical versus the structural in markets. And we’ll come to the medium-term inflation debate. And there, I think people are been really bad at decomposing the desire to socialize with the desire to re-leverage because only if we get the credit impulse and leverage going in the economy that you’re going to get velocity of money moving. And the opposite is happening. U.S. households and corporates are effectively deleveraging because bank lending is contracting. So, honestly when you look into the guts of this reflation trade, I don’t think it’s scary at all. I really don’t. I think it’s quite superficial.

Pattullo: We are big fans of Richard Koo, as you know, Adam, and he coined the phrase, “the balance sheet recession,” which helped us explain the Japanification of Europe and I guess more recently, America. But just briefly, I mean, he called for a massive fiscal expansion, a wartime fiscal expansion pre-COVID, yes. Because, essentially, when you have the consumer and corporate deleveraging – so running surpluses – it’s the government’s job to take that surplus and spend it on behalf of the nation and they should spend exactly the same amount of money which is being saved. So yes, we had the war against COVID, if you like, and the U.S. government and the Japanese and European governments correctly, massively expanded fiscal policy, which were combined with monetary policy to spend some of those surpluses and create a deficit on the other side of the balance sheet, if that makes sense. And obviously, you’ve got exports and imports as well. So, this is all good news.

The problem is, are they spending enough? And I’m sure Jen wants to go in here. Are they spending enough on the fiscal side, like borrowing enough? And Japan basically didn’t. And we’re not convinced the Western world is borrowing enough at the government level to offset the deleveraging that Jenna was talking about in corporates and individuals. And secondly, where is it getting spent and how is it getting spent? And I know Jen’s got some interesting views on that as well. And so, I guess net-net, the danger is you still get a net leakage in an economy and then you get a disinflationary environment. And the way the whole Japanese economic miracle was driven because they had a net input to the economy essentially because people borrowed and it was all driven by credit and leverage. That miracle Japanese economy, it was driven by leverage.

Barnard: Okay, I think every reflation trade has got to have a big question mark. Yes, to get people debating whether this is the regime shift that everyone’s anticipated. And in 2010-2011, UCC graphs, the central bank balance sheets and QE [quantitative easing] was going to cause inflation. Of course, it didn’t, and you know, all it did was essentially boost bank reserves and the velocity of money never picked up. Okay, it never got lent out into the real economy.

And then in 2018, do you remember there weren’t enough U.S. truckers? Yes, that was the kind of late-cycle inflation trade and it was going to be Phillips curve and wage inflation. And this was the big breakout after the corporate tax cuts. The corporates were going to give wage rises to people across America. And this time around, it’s the focus on the fiscal, the U.S. fiscal, yes, which is going to be the catalyst for a big regime shift in inflation. And that is obviously a big debating point. But the one thing I would say that’s missing here, and we’ll attack that fiscal issue in a second, but nobody is paying attention to China. And normally, these reflation trades do emanate from China, certainly over the last 12 years. The Chinese manufacturing recovery seems to have peaked a month or so ago, and they’re obviously tightening credit conditions as we speak, and it hasn’t reflated the global economy.

And the other big shift that’s going on that isn’t getting any attention is the contraction in bank lending in the U.S. Really big, big deal for us, big deal for us because we follow the work of Richard Koo balance sheet recession in Japan and we’ve seen this moving in Europe as well. And it’s not the public sector that creates inflation. It’s the private sector that creates money and inflation through bank lending. There’s something going on here that households are using these stimulus checks to pay down debt. Some of it’s being saved and that will be spent as we reopen. But a lot is being used to pay down debt. And corporates, this is very interesting as well. Corporates now, we’re seeing commercial industrial loans contracting. Yes, I mean a good example was last quarter’s earnings. I think Bank of America deposits grew 23% and their lending shrank 5%. We saw that across a number of U.S. banks. And like, for us, when we see that, our antennae is up because that is disinflationary, and economics is a social science. If people’s response to the COVID crisis is to de-lever and pay down debt, that’s concerning, that’s concerning. And obviously, it’s a work in progress. We’ll see how it goes. But if you pay down debt, you don’t re-leverage when the economy opens up and you go to a restaurant. So, this is, we’re seeing a lot of corporates on the ground actually bringing their leverage targets down, medium-term leverage targets post-COVID.

It’s very interesting things going on. So, I would say the market is completely obsessed with fiscal for obvious reasons. And whether this fiscal spending actually will lower or increase the long-term productive potential of this, of the U.S. economy and central bank talk (inaudible) is a big debate. It’s a huge debate amongst economists. Some people think it will actually lower it, long-term interest rates. Others think it will be spent productively perhaps and increase it. But all I would say is that the maniacal focus on that debate is missing the China angle and it’s missing what’s going on in the private sector. And I’m really, you know, the desire to socialize and the desire to re-lever, that’s the cyclical versus a structural component. And that is yes, it’s some … I think it’s looking a bit disinflationary at the moment.

Pattullo: I mean at least people are happy to put money in the bank this cycle. Because the great [Global] Financial Crisis, people wanted to take money out of the bank. But I do think as some economists talk about money supply, but they forget about the demand for money, yes. And if you read the European and the Fed Bank lending service, they basically said, “Well, the banks are willing to lend money.” But you need someone to want to borrow it, yes? I mean so that’s massively important. And that’s the movie we’ve seen before in Japan and Europe.

And then I think the other point, as Jen says, is, you know, how is that fiscal money getting spent? Someone’s getting de-levered? And I think, you know, if it just gets consumed, that’s fair. The multiplier on that is obviously really low. If it gets invested in a productive capacity in genuine infrastructure products and broadband and airports and productivity and robotics and all that sort of stuff, one could argue that the multiplier effects of that are better. But there’s obviously massive debate about the size of fiscal multipliers. And the point I was trying to make was, is that fiscal money getting well spent in a productive investment sense rather than getting consumed or delivered to offset the deleveraging which is going on by individuals because they’re getting this money from somewhere else and corporates. And I guess we’re not totally convinced. And I think Larry Summers, who kind of of the view that there might be overcooking this, which we don’t really agree with, but I think what he’s really saying is that the fiscal money has to be invested in productive capacity and efficiency and not consumed, you know, to re-engineer the whole U.S. economy. So, that that’s the kind of way we see the world, you know.

Barnard: It is, and the other thing I would say on fiscal is any fiscal boost this year is a fiscal cliff next year if it’s not repeated. You know, because the rate of change of fiscal matters for economic growth. So, the way that we’ve got the inflation base effects this year, then you get the credit problems next year in terms of growth and less, as John said, to spending it year-in, year-out, particularly on productive things, which will pay back. So yes, I mean look, I don’t want to sound like totally dismissive of this. There is always an unknown factor and there’s always debate. And the fiscal debate is the one this time around. And frankly, we don’t know when this narrative is going to burn out. We don’t. We’re tracking a few things you know, positioning, sentiment, various other indicators. And, you know, there’s normally very kind of negative seasonality for government bonds January through March. That’s pretty typical, and sometimes it lasts up to June, doesn’t it, John? Occasionally, you get the kind of June spike and you’ll … So, you know, we need to be, we do need to be respectful of it, and we have been short duration last year and coming into this year. And, you know, macro is really about narratives, watching these waves, you know, begin, crest and then crash. And I think this one will eventually crash.

Pattullo: We keep telling each other we’ve got to be patient and have some perspective, Adam, as well. As you know, that’s your job as a fund manager, you know, as you might just throw in as well that you like this one. Seasonally adjusted inflation is still seasonal, which I know sounds crazy. But the work we read tends to suggest that inflation tends, even seasonally adjusted inflation, tends to be larger in the first half of the year than the second half of the year. I know that sounds nuts, but it’s actually statistically true.

My parting thought would just be, you know, economics is a social science. It’s not an actual science. It’s a social science. The long-term answer to this whole reflation debate once you get away from all the price volatility this year, is really, is going to be about the private sector’s reaction to this crisis. If the months pass and the quarters pass and the years pass, are people going to be re-leveraging or deleveraging? How is behavior going to change? And I find it very hard to believe that the second major crisis in the last, you know, 10-odd years that this is going to be a catalyst for re-leveraging.

Okay, so I just, I really find it hard to be convinced by the regime-shift camp that’s being pushed out there. And I, frankly, don’t think most managers are worried about this year’s price volatility in the cyclical arguments. The debate is really about the medium-term potential for regime shift. And unless these, you know, supply-constraint, bottleneck-driven, commodity-driven inflation is passed through to consumers, which it hasn’t been in the past and starts a wage price spiral and we get money moving through the economy by re-leveraging, this thing is just going to peter out.  It’s going to peter out.

So yes, we’ll watch, we’ll watch all that and we’ll see how people react. But I find it very hard to believe that this is going to drive a shift in psychology that causes a desire to leverage up and take on credit.

Pattullo: No, I agree. I mean it’s slightly counterintuitive to us that after the second major crisis that we’ve all struggled through that one would then change behaviors to want to borrow more money and be confident in the future. I mean it just seems crazy. But just don’t confuse that with the next six months, which hopefully will be fun times and we can all get out and do what we used to do. But also, you know, there are structural changes going on. Like I don’t know, you know, the way we shop or the way we probably won’t go to the cinema and all this sort of stuff and that digitalization I think has changed behaviors a lot as well. And we’re not going to live in quite the way or operate in quite the way that we used to. And that acceleration in structural change via digitalization is probably pretty deflationary as well, I would suggest. On the more positive side, U.S. housing market is pretty hot in a borrowing sense, as is car loans because a lot of Americans have obviously borrowed money to buy cars because they have to. But we’re probably okay. But you know, I mean it’s not all like everyone’s deleveraging everywhere. It’s just at the margin, it’s a bit, it’s a bit ho-hum, you know.

Barnard: I think the point I was trying to make was that there’s no airtime given to that. And the fact that China, yes, that’s all I was trying to say is like the debate is entirely focused in one place. But these other factors and like China – China choose the lack of import growth and that’s the detracted 1% from global economic growth in the last year. So, China has recovered, but it’s done it in such a way that it’s detracted from global growth. I mean that is, that I think is way more important than this year’s U.S. fiscal stimulus. And you know, all these reflation debates for the last 10 years have been about China, haven’t they?

Pattullo: And Adam, you wouldn’t believe the, you know, the old European growth miracle argument around 2017-2018 was basically all European exports to China. The delta was just massive, especially in German and Italian exports. But as Jen says, the Chinese are now trying to import-substitute and just produce a lot of that stuff onshore, and so, you know, it makes us actually a bit more negative on European growth than we normally are because that massive export market is not going to be as strong again.

Hetts: Okay, well that was great. Thanks, John. Thanks, Jenna. Clear thinking as always and personally, I hope I speak for a lot of listeners that it’s been getting increasingly difficult to cut through a lot of the optimism and a lot of the headlines in the market and look for this kind of counternarrative. And I think they brought out a few key points we should all be aware of and maybe even weary of in what seems to be the broader narrative in a lot of the market optimism. So, thanks again, John and Jenna.

And as always, the views of Janus Henderson’s investment teams and thought leaders are freely available within the Insights section of our websites. Thank you for listening. We look forward to bringing you more conversations in the near future.

 

Inflation: a general increase in prices and fall in the purchasing value of money.

Reflation: expansion in the level of output of an economy by government stimulus, using either fiscal or monetary policy.