Trading Reflation

In the world of global macro, it is a truly unprecedented time. The west is deflating through lower CPI indexes and increasing unemployment, with the dollar in meltdown, equities at a top, the FED taking unprecedented action to stimulate, and cryptocurrencies are exploding exponentially. A blue wave sweeps across America after a tumultuous four years under President Trump opening America to stimulus, clean energy, and infrastructure spending.

The unprecedented nature of fiscal stimulus deployed by Western governments in the wake of the Covid-19 pandemic presents the case for inflation, combined with the rising cost of commodities from exporting nations. Food prices have been rising strongly through changing weather and increased demand.

In the wake of the collapsing dollar, as monetary systems adapt to the digital age, foreign economies dependent upon the export of commodities such as oil, metals and materials see their export sales increasing due to a weakening dollar vs their home currency. This in turn pushes up the cost of commodities.

While the following does not constitute trading advice, the author outlines some possible opportunities to benefit from an inflationary macro environment.

Energy and commodities

To benefit from rising commodity prices due to increased demand from infrastructure spending and electrification coupled with import demands from China, the Aussie dollar vs the US dollar [AUD/USD] offers a good proxy for increasing commodity prices. Australia is a key commodity exporter of coal, iron ore, gold and petroleum. AUD/USD is up thirteen per cent year-to-date (YTD), or 36 per cent from the March 2020 low.

Figure 1: The Aussie dollar has continued to see strength as demand for commodity exports explodes after China re-opened its economy in 2020. It is important to note the supply demand dynamics which impact the underlying moves in a currency alongside any speculative patterns or technical trades in the context of currencies.

For more specific energy plays, a diversified oil supermajor with interests in green energy will provide a strong hedge such as Total. BP stated in their 2020 state of the market outlook annual report that peak oil demand will not arise until at least 2035,which can be found here. Oil is a key ingredient for aviation, shipping, land based transit and a base feedstock for refined petroleum products as well as household and durable items. While oil is still at risk in the shorter term from Covid-19 restrictions, longer term oil supermajors present a pristine opportunity to purchase an out of favour sector with strong prospects across global markets and verticals of the business.

Figure 2: Brent Crude has continued to rally, through a bleak demand picture, toward its 2019 level of $70/BBL (barrel).

Housebuilders and materials stocks provide strong natural hedges against inflation who can directly pass these costs onto the consumer. While lumber futures exploded amidst the pandemic, as lumber mills were caught out from the impact of lockdown, along with the mass exodus from cities as work from home (WFH) became the normality for most city jobs, demand for housing through summer 2020 remained robust in the U.S. Housebuilders and materials businesses have the advantage of passing on the cost directly to the consumer leading to inflation in the housing market. A similar phenomenon was seen in the U.K. during the Summer as the Government renounced stamp duty tax on property sales in a bid to boost home moves. U.K. construction has continued to hold up amidst the lockdown with many developments continuing to progress.

Figure 3: A personal favourite, GreenBrick Partners [$GRBK], has continued to see strength in new home sales and home starts across its markets in the US. This business was spun out of Greenlight Capital, a fund run by David Einhorn, who still holds a significant position at 48 per cent. The details of this can be found in his latest letter posted here.

The final opportunity would be to trade the spread between value and growth. Value has had its worst run in history and has massively underperformed the growth market underpinned by central bank interventions. Further, during the Covid-19 pandemic in wake of the current low rate environment, big tech names such as Amazon, zoom, and cloud services have seen multiple expansion as participants buy popular work from home [WFH] stocks. High gross margin tech businesses also received a strong bid for their cash flow yield during the low rate environment. During an inflationary period, cyclicals, industrials and financials are likely to outperform as growth lags.

This trade could be expressed as a structured long/short etf trade or through long dated options for improved risk adjusted returns, whereby the participant goes long the value index, such as Vanguard’s VTV, while short a growth ETF such as Vanguard’s VUG.

The author does not hold any positions in any securities outlined in the article nor does this constitute financial advice.