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IPFS News Link • Economic Theory

The Great Rotation

• by Kevin Smith and Tavi Costa

With the democratic sweep in place, we are about to experience even more of the double-barreled fiscal and monetary stimulus that we saw in 2020. Overwhelmingly today, such policies have served to incite animal spirits toward financial assets. Investors are already positioned, all in, on both stocks and bonds in the US creating a highly imbalanced market. The problem is that money printing married with fiscal spending is crashing head-on with an emerging commodity supply problem that will likely stir up rising inflation which is bearish for both equities and fixed income. Get ready for a volatile 2021, the year of reckoning for twin asset bubbles as the world attempts to emerge from the Covid-19 pandemic.

The macro setup is in place for a self-reinforcing unwinding for stocks and rise in commodities akin to 1920-21, 1973-74 and 2000-02. On the long side of this trade, there are merely two sectors in the US stock market – energy and materials – that offer substantial value and upside potential today as part of this macro reconciliation. We believe the smart money is already rotating out of historically overvalued equities and fixed income securities and into undervalued commodities. Soon it should become a stampede, a reflexive great rotation.

The Fed is determined to increase the rate of inflation to ease the record debt burden dragging down economic growth. The fiscal powers will be playing along, so inflation is indeed what we are likely to get. Long term economic history proves that the forces of rising wholesale and consumer prices cannot easily be brought back under control by central banks once they get loose.

But what about the "output gap" in recent years, the theoretical paradox holding inflation in check due to an underachieving economy? And what about the deflationary forces of technological innovation and aging demographics? At this stage of the macro cycle, in our analysis, inflation is all about the "input gap", i.e., supply shortages of primary resources. While the "new economy" has been enjoying the limelight in recent years, the stage for "cost-push inflation" has been set due to underinvestment in the "old economy" now that policy makers are about to pull out their biggest bazookas yet to boost aggregate demand.