Looking at Reflation and Stagnation Trades

Mr. Market has begun to show clear signs of split personality disorder in recent weeks. Now that investors have exhaled in relief that a deflationary apocalypse has been avoided, the new reality of reflation and stagnation is sinking in…

On the one hand, certain areas of the market – the ones much favored in the big run-up – have started to wilt and fade as the much-lauded “green shoots” turn brown. On the other hand, areas of the market which didn’t participate as much in the rally at first have started showing signs of life.

Take the grain markets for example. Foodstuffs like corn, wheat, soybeans and sugar have been red-hot in recent days.

We can see this in the Powershares DB Agriculture Fund (DBA), which Macro Trader has been long for a number of weeks. (We took partial profits earlier this week, and continue to ride the move with the remainder of our position.)

DBA, which is NOT built around “total return swaps” like other inverse/leveraged funds, is essentially a basket of futures contracts – primarily wheat, corn and soybeans, with sugar thrown in for good measure.

Commodity after commodity has roared back to life, thanks to a combination of renewed inflation expectations, a cratering U.S. dollar, and newly bullish fundamentals. Let’s take a closer look at some of DBA’s components to see what I mean.

Prices as high as an elephant’s eye

“Corn prices surged to a six-month high,” Bloomberg reported earlier this week, “after the U.S. government said domestic demand will exceed production for the third time in four years, slashing reserves by 28 percent.”

Corn inventories are expected to fall even as the various demand sources for corn – food, livestock and fuel – rise an estimated 3.5% next year.

Soybean prices, meanwhile, recently hit seven-month highs on the CBOT (Chicago Board of Trade) after U.S. stockpile forecasts dropped. Beans were also boosted by word that the Brazilian National Agriculture Confederation, a major farm lobbying group in Brazil, would press for limited soybean acreage in the coming planting season to help keep prices firm.

And finally sugar, not to be outdone, recently hit 34-month highs – their highest level in nearly three years – on “poor crops and robust demand,” according to the Financial Times. A failure of India’s local sugar crop was seen as a big price booster. “Swings in Indian sugar output, which move the country back and forth from exporter to importer, are a critical factor in global prices,” the FT reports.

Wheat is the one area with potential for disappointment, relating to large India stockpiles that could be released onto the market later this summer – hence Macro Trader’s willingness to take some gains off the table and watch closely as further developments unfold.

Reflation and stagnation

Agriculture is thus one area where the market is doing well. Other foodstuffs not mentioned, like cotton and coffee, have also seen big gains in recent weeks. On top of that, various agriculture-related equities have been performing well and look to have strong potential upside in the coming months.

Along with base metals, agri has been showing signs that the “reflation trade” is on. There is a new and aggressively bullish stance emerging on hard assets and inflation-themed plays, including everything from base metals, to gold and silver, to crude oil and natural gas... and well-run companies related to all the above.

China, too, has had a hand in pumping up the reflation trade with its aggressive stockpiling of base metals. (A few weeks back we wondered aloud in these pages if good Dr. Copper, the “metal with a PhD in economics,” was being goosed by China buying. That hunch was more or less correct, as Beijing doubles down on industrial inflation hedges with a vengeance.)

Other areas are dropping

But all is not rosy and cheery for the recovery-minded bulls, as other, weaker areas of the market can attest. At the same time that inflation-linked themes are hopping, other econ-related data points are dropping.

“U.S. railroad freight traffic is running about a fifth lower than a year ago,” The Wall Street Journal reports, adding that the news “is one of several less-obvious indicators that all isn't well, despite the financial-market rally since early March.”

The underlying reality, as the dismal freight numbers point out, is that a change from “bad” to “less bad” on the economic data front doesn’t mean things are necessarily getting better. It only means we aren’t free-falling quite as fast as we were.

Think of the skydiver hurtling towards the earth at an astonishing rate. A few thousand feet above the ground he pulls the ripcord and – hooray! – his rate of descent has been arrested, to the point where he is pleasantly drifting rather than free-falling now. But in which direction is he still headed? And where exactly is he going to land? (Let’s hope it’s not an alligator swamp...)

Consumer discretionary

The budding hope that U.S. consumers would come bouncing back with wallet intact also took a hard knock this week. April retail sales were down for the second month in a row, coming in below expectations and breaking the bulls’ happy winning string of positive upside surprises.

Brian Bethune, chief U.S. economist at IHS Global Insight in Lexington, Mass., believes the “green shoots” talk was premature. “There are some preliminary signs (of improvement) in certain areas of the financial markets,” Bethune tells Reuters, “but in terms of the real economy, we are still a long ways off.”

To which we try (and fail) to resist the temptation to say: “Well, duh.”

A classic combo

The environment we are headed into – and the view Mr. Market seems to (perhaps) be acknowledging now – is a classic combo of wearisome economic stagnation and creeping paper-fueled inflation. One acts as a fearsome headwind, blowing in the face of consumer-oriented names reliant on economic recovery to justify their newly bid-up valuations. The other acts as a powerful tailwind, further bidding up the price of inflation hedges and hard assets.

The main worry that has wracked markets these past few months, a relentless deflationary downward spiral leading to Great Depression 2.0, has now more or less been put to bed (at least in the mind of investors at large). Upon coming to the realization that we’re not all going to die, a massive post-apocalypse bear market rally ensued as investors audibly exhaled and the “green shoots” meme excited suggestible minds far and wide.

But now the follow-on reality is slowly sinking in that, while we may not be dead ducks, we’re still far (quite far) from being out of the woods. And that means an unpleasant combo of debt-hobbled economic growth, budget-busting government deficits, and persistent fiat currency erosion as far as the eye can see.

Macro Trader’s special recipe for an environment such as this is two-pronged. We are scanning the landscape for bearish trading opportunities in overhyped and overinflated consumer discretionary-type names, still pumped up from the short-covering aspects of rally and vulnerable to fresh disappointment, while simultaneously ferreting out bullish opportunities to play the “reflation trade” (in everything from ag to energy to metals) on the long side.

Comments

[yellowhoard:]

DBA is one of my core holdings.

The way I see it, if the market sells off sharply, the Fed will QE it's way out of trouble, good for ag prices.

If the economy recovers, ag demand will rise as well.

Seems like a win/win to me.

May 17 08:55 AM

[RiskReturnO...:]

Simply plot the charts of DBA, XLE, and XLY, and you can start seeing some interesting patterns over the past few weeks.

When inflation expectations increase, such as higher PPI/CPI in food and energy, DBA and XLE do well, but consumer discretionary (XLY) suffers.

Personally, I'm bullish on DBA and XLE as the longer term trend is toward higher agr and oil prices, resulting from weaker dollar, China demand, and reflation trade.

However, the moment these trades hit resistance (e.g., gas prices stabilize below $3 for few weeks, oil drops to $40-$50 range), it will be time to rotate back into Consumer Discretionary names, which has been correcting in the last week, following a strong rebound since March lows.

May 17 07:05 PM

[Momintn:]

As Americans move back into the stock market, they will buy brand names they like, many of which are Consumer Discretionary. Seeing as we don't produce much oil, I doubt they will want to invest there as much, especially now with the Obama administraton. And few investors invest in commodities in the first place.

May 17 09:19 PM

[johnbee:]

Agriculture is the best means of defending against inflation, stagflation, the dollar and other competitive currency devaluations. Other hard assets such as copper and oil are not essentials and have risen too far already especially oil where the speculators with their tanker hoardings are trying to push the price up. The Chinese will slowly move out of the $ and buy non $ assets in commodities and commodity suppliers and try to set up a new global reserve currency based on hard assets; not gold.

May 18 06:40 AM