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Meanwhile, the reflation trade could still be challenged by setbacks in combating the COVID-19 pandemic, especially by the spread of the delta variant or the emergence of more transmissible or virulent variants. (ddp)

Markets Reflation trade looks back on track

09 August 2021, 1:20 pm CEST, written by UBS Editorial Team

Employment data on Friday helped allay fears that the US economy is losing momentum, with job creation for July beating expectations at 943,000. Unemployment—while still above pre-pandemic levels—declined to 5.4% from 5.9%.

The data beneath the headline figures were also encouraging. A 380,000 rise in employment in the leisure and hospitality sectors indicates that economic reopening is on track and businesses are having less trouble finding workers than earlier in the recovery. The U6 measure of underemployment, which measures people who are working part-time for economic reasons, declined to 9.2% from 9.8%.

So, we believe the reflation trade, which had recently gone into reverse, will come back into focus on a more sustained basis:

1. US yields are being driven more by positive growth data than by worries over inflation. It is notable that US 10-year yields have not increased significantly after the past two US consumer price index releases, which have shown the largest increases in more than a decade. However, the 10-year yield did rise around 7 basis points following the stronger- than-expected employment data on Friday. This suggests that markets have taken on board the Federal Reserve’s recent message that they view inflation pressures as transient, and that the timing of monetary tightening is more likely to be determined by the pace of employment gains.

2. After a period of relative weakness, cyclical parts of the market have recovered ground. Recently the rotation from growth into value stocks that occurred earlier in the year went into reverse. Since the start of July, for example, the Russell 1000 value index gained 1.5% versus 4.2% for the growth index. Last week, value stocks managed to keep pace with growth and outperformed on Friday. Meanwhile, for the large cap S&P 500 the biggest gains were in cyclicals, including a 4.5% rise in bank stocks versus a 1% gain for technology stocks over the week. For UBS marketing purposes

3. As the economy is recovering, corporate profits are rising even faster than GDP. We expect the US economy to expand by 6.5% this year, with earnings up 40% for the S&P 500 constituents. The second quarter earnings season, which is winding down with 90% of companies by capitalization having already reported, has continued to impress. So far 89% of companies have beaten earnings forecasts by an average margin of close to 20%, with financials reporting the largest upside surprises.

But risks remain. While inflation data has so far not been a major market mover, Wednesday’s July Consumer Price Index release has the potential to cause volatility, especially given expectations that inflation has passed the peak. Click here for more on strategies to protect against inflation. Meanwhile, the reflation trade could still be challenged by setbacks in combating the COVID-19 pandemic, especially by the spread of the delta variant or the emergence of more transmissible or virulent variants. Click here to read more on ideas for downside protection.

Main contributors - Mark Haefele, Christopher Swann, Vincent Heaney, Brian Rose, Andrew Thompson

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Original report - Reflation trade looks back on track, 9 August 2021.

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