Reflation Sensation: What Would Trigger the Rotation into Value and Commodities?

The price action over the past few days has taken on a more positive cyclical dynamic. Dr copper, oil, iron ore and industrial metals appear a little more perky and “value” sectors of the equity market have started to trade with a little more strength. As has been widely discussed, the rally in equities so far has been famously narrow and led by technology and health care in the United States. Therefore, a sustainable rotation into cyclical and value stocks would be bullish. Our sense is that it is probably still too early to expect a durable rotation. However, there are three key factors to note.

First, the unprecedented speed, size and scope of the US policy response is now widely appreciated. Moreover, the Fed has been very clear that the commitment is unlimited. However, more important for commodity markets, mining and global cyclicals is the recent policy developments out of China. As we noted last week, credit creation picked up significantly in China in March and April after a very weak February. China’s M2 money supply growth for the first four months of the year now sits around $1.5 trillion, or an annualised pace of around $4.5 trillion. To put that into perspective, that pace of credit creation is similar to the year after the Lehman crisis, when Chinese M2 accounted for a significant share of global M2 growth of $7 trillion.

As we have noted previously, China’s credit impulse (change in the pace of credit growth) is a strong leading indicator of industrial activity, infrastructure and real estate in China. In turn, the indicator is a reliable leading indicator of industrial metals prices, emerging market cyclicals and reflation (chart 1). It is plausible that the acceleration in the China credit impulse has also been in anticipation of the upcoming National People’s Conference where more detail on fiscal policy support will be announced. Recall that monetary and fiscal policy in China are closely connected via the financial system channels.

Second, China’s fixed income markets are also consistent with reflation. The 10-2 year yield curve has steepened considerably more than the equivalent curve in the United States (chart 2). Of course, China entered the episode first and therefore started to re-open and recover earlier than the rest of the world. On a range of measures, activity has largely (not entirely) returned to pre-crisis levels. The big picture point is that the steepening of the yield curve is consistent with the credit impulse.

However, from a global perspective it would be more encouraging if there was a similar rise in Treasury yields and steepening of the yield curve in the United States. Historically, US 10 year yields have also been a reliable leading indicator of global growth, (re-inflation) expectations and the performance of value/cyclical sectors such as industrials, materials (mining), energy and financials (chart 3). For now, both US 10 Year Treasury yields and the yield curve remain depressed near the record lows. While there is an element of central bank intervention, our sense is that the Fed would be encouraged by normalisation as a signal of reflation.

The final point to note is that cyclical sectors in EM/Asia and globally trade at a depressed valuation on an outright basis and relative to the United States (chart 4). Moreover, given sector leadership in the rally so far and indeed over the past decade the prevailing bias and positioning in these sectors and Asia more broadly is extremely depressed. Of course, that has persisted for some time. On the positive side and as we noted in the new paranormal, the shift to aggressive and sustained fiscal policy is the probable catalyst for a genuine rotation into underappreciated deep cyclical and value stocks.