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Michael Gayed: Oversold Deflation May Mean Reflation


Deflation has been the biggest worry of all. Maybe that's why inflation may begin to make a comeback.

My biggest weakness is my sensitivity. I am too sensitive a person.
-- Mike Tyson

One of the biggest disconnects of all since the QE3 rally began is in the relationship of developed market stocks to inflation expectations.

Historically, when inflation-sensitive areas of the market underperform, equity investors sell off risk assets and favor fixed income. When demand for inflation-sensitive areas of the investable landscape rises, then markets tend to follow in absolute terms higher. In other words, inflation expectations tend to set the conditions under which stocks or bonds outperform each other. Last year, I noted the disconnect aggressively, but the honey badger US stock market did not care. Emerging markets, commodities, and most notable gold, and Treasury Inflation Protected Securities (TIPs) reacted accordingly to the deflation pulse.

Despite trillions of dollars, inflation hasn't really happened in anything except asset markets. Inflation expectations have been muted. This may be about to change, in what appears to finally be some signs of life in the true reflation trade. Take a look below at the price ratio of the iShares Barclays TIPS Bond Fund ETF (NYSEARCA:TIP) relative to the iShares Barclays 7-10 Year Treasury Fund ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEF. This is one way of tracking inflation expectations, as a rising ratio indicates demand for inflation protection is outweighing supply.

Note that a strong bounce has occurred as of the last several days on support, in what has been a prolonged period of nothingness for reflation. Should the trend firm, this would be highly beneficial toward everything that got slammed in the first place, most notably emerging markets and commodities, in that order. Some of this may be on anticipation of a firmer payroll report to come, but I think something more interesting may be happening. While unusual, perhaps the deflation camp is beginning to question if stocks are actually right about the future. After all, robust economic cycles are defined by inflation, and not deflation (for proof, ask Japan).

Could this explain why financials are showing signs of life again as I noted in my most recent post on the Buzz & Banter (subscription required), and explain why, despite fears of an imminent collapse, emerging markets are holding their own in recent weeks? My firm's ATAC (Accelerated Time and Capital) models used for managing our mutual fund and separate accounts currently favor US small caps given better relative momentum, but a trade will stick in the reflation trade sooner than not. A continuation higher in the above ratio would be equity-supportive and harmful to fixed income. Yes -- it is bullish, but the way to play the trend is with those areas most sensitive to it.

Twitter: @pensionpartners
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No positions in stocks mentioned.

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