Debt looms over reflation trade

Global levels hit record high of $233 trillion

We believe 2018 will prove to be a very important year for investors, not only because of the unprecedented level of euphoria surrounding the U.S. equity market, but more so due to the ongoing global reflation trade that both speculators and investors are piling into.

This reflation trade is having a tremendous impact on global equity markets, commodity prices and, most importantly, currencies.

The thesis is that the global economy has shifted into high- growth mode and therefore the demand for commodities will rebound as inflation finally begins to take hold and central banks accelerate interest rate hikes.

So far, this has been an excellent trade, with commodities such as crude oil rallying more than 50 per cent from their mid- 2017 lows. Long positions in oil have also been building to new record highs, with speculators clearly betting on this momentum to continue into 2018.

To add some perspective on the magnitude, net long positions are currently 40 per cent higher than their mid- 2014 highs, and an astounding 4 times higher than their 2016 lows.

Other related markets have also benefited from this trade, with the MSCI Emerging Markets i ndex rocketing nearly 36 per cent last year. That index is now roughly 10 per cent above its mid- 2014 highs — thereby completely erasing the impact from the global deflation sell- off that occurred three years ago.

Most importantly, all of this is being reflected in the U.S. dollar.

The dollar index ( DXY) peaked in December 2016 and has subsequently lost nearly 13 per cent, shrugging off what should have been positive effects from U. S. tax reform and a Federal Reserve about to embark on a tightening cycle.

Thirteen per cent is a very material move for a currency, and the USD has now erased more than half of its three-year gains.

Since commodities are priced in U. S. dollars, they often move in opposite directions, so a large sell-off in the currency will typically correspond with a large gain in the commodity. For example, one can see the strong relationship between the price of oil ( inverted in attached chart) when plotted against the dollar index.

The problem though is that many are expecting a return to near- triple- digit oil prices and a corresponding sell- off in the U. S. dollar at the same time that U. S. shale producers are ramping up production after already adding more than 1.2 million barrels per day of output from the September 2016 lows. Looking ahead, the EIA has recently revised its production forecast for the move in oil prices and are now expecting another 970,000 barrels per day of gains this year.

We really hope global demand growth expectations materialize, otherwise we will once again be out of balance at a time when speculative long positions are at alltime highs. The last time this happened the unwinding of the large long position in 2014 sent oil prices crashing from $107 per barrel to a low of $26 per barrel.

Overall, our problem with this reflation trade comes down to a four- letter word: debt.

According to a recent Reuters report, global debt levels are now at a record high of $ 233 trillion, up from $ 142 trillion in 2007 and $ 87 trillion in 2000. Not surprisingly, pundits are touting the asset side of the equation as they always do during market highs, but remember asset prices can move in both directions while debt remains a constant. This lesson is quickly remembered during a correction — which we have not seen for some time.

So, here we currently are with debt levels nearly 65 per cent higher in the past 10 years while interest rates are at ultra-low levels. Meanwhile, many are expecting commodity demand and economic growth to continue to reflate against a backdrop where central banks are about to either end their easing and/or begin tightening. Think about that.

We hope they’re right because the cost of being wrong could prove to be catastrophic — simply ask those who bought oil in early 2014 on the same expectation. Perhaps this is why Canadian investors are more cautious these days, with the S& P TSX only gaining six per cent last year (excluding dividends).