Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

<< Back to HyperNormalTimes archive

January 10, 2021

Timing The Reflation Trade, Solvency Tests & Backing Britain

There is a headline today to an article in the Sunday Times by the UK’s Chief Medical Officer, Chris Witty, “We are far from out of the woods – please do not act as if we are”. He is of course aiming his piece at the UK public’s attitude towards the risk of the virus and its adherence to the latest lockdown restrictions in light of the rapid spread of the new variant. However, he may not be aware that his warnings might also apply to the recent behaviour of financial markets.


We hardly need reminding that 2020 was a strange year. But one thing markets weren’t overtly concerned about was the risk of inflation. Demand for many goods and services were decimated and the productive capacity of many sectors were put into enforced hibernation. The UK RPI was at 1.8% a year ago and steadily fell to a low of 0.6% in November. Clearly nothing to see here.


Fast forward to 2021, the financial world is in the grip of The Big Reflation Trade with articles everywhere cautioning about the risk of inflation. Bond yields are rising, equities are rising, the dollar is weakening and there seems to an outbreak of bubble mania: SPACS, IPOs, Cryptocurrencies, Commodities and Tesla shares are all held up as clear evidence of inflation, potentially of ruinous proportions. What was a fringe interest group in financial markets only a few months ago has become the consensus view. Despite having warned of the latent inflationary risks inherent in the way the world has responded to the impact of the pandemic, I now fear I am party to a crowded trade and one that could become dangerously over populated.

The debate has moved from one of scepticism about the signs of inflation for most of last year, to one of seeing evidence of it everywhere. The triggers for the change in view are a combination of:

  1. The prevailing view of a vaccine moving from, IF we get a vaccine, to WHEN they (multiple vaccines) might become effective in delivering herd immunity.
  2. Increased concern about the exceptional growth in public debt levels and growth in measures of narrow money supply, compounded recently by the cost of further lockdowns.
  3. The move to a Democratic political agenda in the US with consequently larger and more coordinated fiscal and monetary measures to alleviate the pandemic and its economic impact.


Looking back to early November life seemed so much simpler. We were making do with the idea that big tech, big data and software would eat the world, only it was happening much quicker, and most other areas of human endeavour would either become obsolete or would only survive with state intervention. In particular the plight of the UK looked hopeless, outside the EU and its governance dysfunctional (albeit we could take some comfort it never seemed quite on the level of American dysfunction). We were out of lock down, we felt we had been through the worst and were adapting to a world where we could accommodate the virus. Not necessarily a dystopian nightmare, more of a long and chilling Netflix mini-series.

Then everything changed and the Pfizer BioNtech vaccine trial results were announced. The pivot was almost instant. It was as if the we had woken up from a bad dream. Everything was safe and the world would return to normal. In stock market terms everything that was last, now shall be first and vice versa. It seemed clear we were returning to our familiar “normal”. The Biden victory just seemed to neatly underline this view.


Three months on and things have changed. The build-up of inflationary expectations is growing rapidly at a time when most countries are about to go into a double dip recession as the (final) waves of COVD-19 (in its various mutated forms) are beating a fierce backlash across most areas of the Europe, N America and even previous less affected outliers, like Japan. So far this fact has only led markets to strengthen their collective faith in the “Fed Put” and extra government financial assistance programmes, which they now see as inevitable. While this might be right and ultimately inflationary, there is also a critical period ahead of heightened uncertainty and conflicting macro messages. I would liken it to rowing a boat into choppy waters impacted by conflicting currents and tides. The prospects for eddies and upsets, periods of discontinuation, are increasing.


I remain of the view that over the course of the next decade most governments need to undertake some extraordinary policy manoeuvres to reduce their levels of public debt and a controlled level of inflation is becoming an overt policy goal. I also remain of the view that the most analogous decade to the 2020s and a formative one for my understanding of economics, is the 1970s. (Lyn Alden is suggesting the 1930s as another good analogue). However, what this doesn’t mean is that what we are seeing now (or think we are seeing) is necessarily the early signs of inflation. While I fully expect inflation to be with us for most, if not all of the current decade, it still might be too early to go all in, chasing the Big Reflation Trade.


Rather than the early warning signs of overheating, what we are currently experiencing is more to do with disrupted and changing supply chains and a move to more resilient business models and financing structures. A less globalised world, or at least a world less reliant on China for its manufactured goods, might be safer, but it would almost certainly be more expensive. Companies and individuals won’t forget this period in a hurry, and while there is every likelihood of a quick rebound certain areas (such as retail spending, leisure travel and events), the economy will take time to heal. Companies and countries and their citizens are likely retain larger floats, in the form of higher inventory levels, stronger balance sheets and a greater allocation of wealth to long term savings accounts. The memories from the Weimar Republic scarred German investors for decades. Still today the level of German home ownership is anomalously low by western standards. More recently the dotcom bust held in check VC investment and public market adoption of technology stocks, for most of the early 2000s. We don’t yet know what damage the COVID period will have inflicted on our productive capacity and general solvency, but we will bear scars, both real and behavioural.


Jeremy Grantham among other market timing gurus think they see trouble ahead and I suspect the next trigger point might well be herd immunity. VE Day might just be the time to sell and the moment the healthcare marine corps plant the flag of victory on COVID’s shoreline, is when the financial markets have their next wake up call. We can’t know this of course, but this is the moment when the global economies, and their combatants will have to be re-assessed for their ability to walk unaided. Many have been pumped with the drip feed of liquidity, they now must be assessed for their ability to stand on their own. The critical test will not be liquidity, but solvency.


I am not looking to leave the party early, I am not advocating selling up and sitting on the sidelines. Market timing of this sort is not practical. However, I do believe that maybe cash levels should be notched up, investment should be focused on the next bubble rather the ones that have already become apparent. Equities still look like a better overall bet than bonds and gold (and maybe oil) look a better placed than Bitcoin or copper. As Sgt. Phil Esterhaus said in Hill Street Blues, “let’s be careful out there”.


If the Buffet measure of a country’s ratio of equity market cap to GDP is any guide, then the UK and Japan offer much better prospects for equity returns than the US. A move into Japanese equities has been one of very few net new investments made by Berkshire Hathaway in the last 12 months, after selling sizable amounts of US banks and airlines. While the US is at is all time high on this measure and some 50% above its previous 2007 peak, the UK is at only 50% of its historic high and 30% below the level seen in 2007. On this measure UK equities offer an attractive margin of safety.

In the last five years Brexit concerns and uncertainty has choked back corporate investment and kept a lid on corporate valuations. While the US has seen their Big Tech and SaaS heavy NASDAQ go to new highs, it has drawn out IPOs from private hands that have popped and crackled and grown the aggregate capitalisation of its publicly traded equities. By contrast the UK has been largely a spectator and has lost publicly traded companies to overseas and take private acquirers.


The UK now looks like a relatively attractive special case. With a Brexit trade deal done and cut and paste deals with more countries following on, the UK can now be reassessed as a place to do business. It might not be optimal, but it is more certain. The UK has an attractive collection of corporate assets, many leaders on a world stage and trading significantly below valuations of their North American peers. We have already seen a notable increase in UK M&A activity in recent months, I think this will at least continue, if not accelerate. Meanwhile there is also a growing pipeline of privately owned UK businesses looking to join the public markets. City am has identified Checkout.com, Darktrace, Deliveroo and Transferwise as the leading UK IPO contenders with dozens of others rumoured to be looking. The UK has an enviable list of fintech and tech enabled companies in private ownership that could fuel a decent run of equity issuance.


The UK also has a critical opportunity in 2021 to distinguish itself among other economies and capital markets in a more strategic sense. As Matt Ridley points out in the Sunday Telegraph, while the UK often leads the world in self-criticism, none other than The New York Times has pointed out that the UK also leads the world in COVID-19 DNA sequencing. The Oxford vaccine success and the efficiency with which the UK has approved vaccines to date are all indicative of the UK’s relative competitive advantage in the general field of bioscience. As the optimistic Mr Ridley says ” If the next 50 years is going to be dominated by innovation in biotech, as the past 50 were dominated by IT, then Britain is well placed”. With private foundations such as the Crick Institute and the Wellcome Foundation along with world class university research at places like Imperial College, and the Oxbridge Universities, the UK is in contention to make a decent contribution to the next generation of big innovation. Alphabet might own Deepmind, but it is a UK based success story in the application of AI to the world of protein formulation.


My wife spent all day Saturday finalising her training to be one of 30 000 St John’s ambulance vaccinator volunteers. She will be spending many hours over the coming months in a large exhibition hall in London playing her part in getting the UK to herd immunity. The target is 30m doses to be delivered by mid February in order to be able to ease the current lockdown regime by the anniversary of the first lockdown, on March 23rd. This looks ambitious, but it is possible. However, whenever we get to this point, the UK economy will not be going back to its pre COVID levels, certainly not overnight. Inflation will take time to become fully apparent, Chris Witty knows, we are not yet out of the woods.



This communication is provided for information purposes only, and is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. Investors should seek advice from an Independent Financial Adviser or regulated stockbroker before making any investment decisions. Progressive Equity Research Ltd (“PERL”) does not make investment recommendations.

Opinions contained in this communication represent those of PERL and/or our affiliates at the time of publication and PERL does not undertake to provide updates to any opinions or views expressed. PERL does not hold any positions in the securities mentioned in this communication, however, PERL’s directors, officers, employees, contractors and affiliates may hold a position,  and/or may perform services or solicit business from, any of the companies or related securities mentioned.

Any prices quoted in our research are as at the previous day’s close.