"In time, we hate that which we often fear." - William Shakespeare
As followers of my writings are aware, I deeply believe that the primary conditions under which stocks perform well is when inflation expectations are rising. When they are falling, the environment does not favor equities as much as it favors bonds. I have argued that following the Summer Crash, Fall Melt-Up, and Winter Resolution, 2012 would likely be a year of reflation similar to 2003 and 2009, with a "Spring Switch" out of bonds and into stocks likely. Following the first week of April, I noted that my company's ATAC (Accelerated Time And Capital) models were sensing a "mini-correction" was likely, positioning our clients largely out of stocks and into bonds. I have continually stated that should the mini-correction play out as I thought it would, that it would further the case for the Spring Switch finally getting flipped.
Last week a dramatic change to sentiment occurred as credit spreads seemingly out of nowhere widened in a way that suggests a credit event may be underway. I spoke of this in an urgent way last Friday on Bloomberg. European elections and fear over the impact of Greece leaving the Euro seems to have sent worldwide investors into a panic, as deflation expectations returned.
Take a look below at the price ratio of the SPDR Barclays Capital TIPS ETF (IPE) relative to the iShares Barclays 7-10 year Treasury Bond Fund ETF (IEF). As a reminder, a rising price ratio means the numerator/IPE is outperforming (up more/down less) the denominator/IEF.
(click to enlarge)
When TIPS outperform nominal bonds, it means inflation expectations are rising. When underperforming, it means the deflation pulse is beating. I have annotated the chart to show the trends of inflation/deflation expectations over the past three years. Notice that the ratio appears to have peaked in March and was unable to reach for the prior three year ratio highs which I believed would be hit. European elections appear to be the direct reason for this abrupt turnaround.
If credit spreads are able to come back (either on their own or through global central bank intervention), I suspect the ratio will recover above. However, it is clear for now that reflation has been abruptly halted as deflation expectations return.
Disclosure: Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.
