- Traditional safe havens like gold, or currencies like the yen and the Swiss franc are looking shaky.
- Markets are pricing in growth and a pick-up in inflation over the medium term.
- Here are the three ways to capitalize on the rotation out of haven assets, Morgan Stanley said.
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Markets are signalling inflation is going to pick up rapidly, as economic growth takes hold and investors buy assets that benefit from such an environment, such as industrial commodities, cyclical stocks and high-yielding currencies.
However, a more reflationary environment poses a threat to some of the “safe haven” assets that fared so well during the worst phases of the coronavirus market crisis last year, such as gold, government bonds and low-yielding currencies, such as the Swiss franc and even the US dollar.
By Monday, the difference between five- and 30-year US Treasury yields – a common bellwether of reflationary expectations – hit its widest point since 2014, as investors shed longer-dated “safe” government debt in favor of assets with greater returns.
“The risks are now highest for ‘safe havens’ that have outperformed their defensive brethren sharply,” wrote Andrew Sheets, a Morgan Stanley strategist, in a note published Sunday.
Safe havens like gold and government bonds saw record demand during the pandemic, as they are viewed as negatively correlated to the broader market, and investors often choose to allocate their cash to assets like these to weather periods of intense market volatility.
But when the growth outlook improves, haven assets are often first in the line of fire.
What would catalyse growth and inflation?
- Declining COVID-19 infections: US cases could fall by c.50% by the end of April, according to Morgan Stanley, on account of the vaccine rollout and warmer weather. As cases start to diminish, this will allow the government to reopen parts of the economy, leading to more consumer spending and growth.
- Passage of additional US fiscal stimulus: The Biden administration’s American Rescue Plan (ARP) should pass in mid-March, Morgan Stanley forecasts, pumping a potential $1-1.5 trillion into the economy. This should send a fiscal adrenaline shot into the US economy, driving business and boosting GDP.
- Accelerating global growth: With different parts of the world reopening sooner, such as China, Morgan Stanley’s economic forecast is above the market consensus, expecting global growth to kickstart in March/April.
“If they materialize, these catalysts would be significant and should emerge imminently,” Sheets wrote.
Inflation is also a key part of this forecast. Morgan Stanley, and indeed the Federal Reserve, expect consumer price pressures to ‘overheat’, meaning inflation will surpass the central bank’s 2% target, largely due to the unprecedented decline during the pandemic.
Market-based gauges of inflation expectations over the medium term have risen sharply. In the last six months, the five-year “breakeven inflation rate” – the difference between the nominal 5-year Treasury yield and its inflation-linked equivalent – has risen to around 2.35% from closer to 1.5%.
Despite the already significant reflationary expectations and some rallies in the likes of copper, most ‘safe havens’ are still at relative highs. Gold remains 11.05% higher year-on-year and haven currencies like the Japanese yen and Swiss franc are up around 6% and 10% against the US dollar, respectively.
But it is in the decline of these assets that investors have the most to gain, Sheets wrote, arguing that “it’s here – in safe, expensive, low-yielding places – where we think the risk from these three positive catalysts is highest.”
Three trade ideas:
- Buy copper, sell gold
- Gold has had a relatively good year, reaching a record price of $2,089.12/oz in August 2020. The precious metal’s momentum was largely caused by a ‘perfect storm’, with low growth, a weak dollar and low benchmark bond yields, which hit a record low of 0.36% at one point.
- However, as growth picks up, this relationship will start to revert, hitting gold. Increasing real yields, which strip out the effect of inflation, will present substantial downside risk for the gold price, the note said. If the market expectations are right – gold could be a big loser in the short-medium term. 10-year real yields are now at -0.8%, up from -1.07% at the start of January, based on Treasury Department data.
- Alternatively, copper should be a key winner, as it enjoys both strong fundamentals and a boost from the reflation-driven trade, the note said. The expected environment of a steepening real yield curve and growth, combined with a weakening dollar should be a big tailwind, also aided by an anticipated supply deficit in the copper market, which should be supportive to the price.
- Copper is one of the most sensitive assets to the underlying health of the global economy, which has conferred it the nickname of “Dr Copper”.
- Risks to the trade:
- China-imported inventory and secondary supply recovery keeps copper prices soft, the note said. Higher recycling rates mean there is less demand for newly mined copper output.
- Short CHF/CAD:
- The Swiss franc (CHF) is a key haven currency, possibly secondary to only the dollar. It is currently up +4.05% against the Canadian dollar (CAD) year-on-year. In this trade, investors would sell the Swiss franc and buy the loonie.
- However, the Swiss franc could suffer from negative carry – where the cost of holding is greater than income earned by owning it – and low participation in any consumer-led global recovery. It is also already trading at recent highs versus dollar, the note said. The Canadian dollar, which is a commodity-linked currency, should benefit from higher oil prices, which are at one-year highs and could be a key beneficiary of the reopening trade when global travel picks up. Moreover, the currency should benefit from strong US growth and has upside risks to US fiscal policy, the note added. The US is Canada’s largest trading partner.
- Risks to the trade: Weaker global growth and lower oil prices.
- Long CNH/JPY:
- Here, investors would sell the Japanese yen, which is often used in carry trades – where traders will sell a low-yielding currency to buy a high-yielding one and pocket the difference in interest rates on each – and buy the offshore Chinese yuan, which trades more freely than the onshore yuan (CNY).
- Year-on-year, the offshore yuan (CNH) is up 3.8% against the Japanese yen.
“A combination of a trade surplus, reduced services deficit, lower tariff risk premium post-elections is in favour of CNY,” the note said. Diminished carry in other currency crosses make CNH a relatively attractive carry currency with good fundamentals, the note added.
- Risks to the trade: An equity sell-off, or renewed US-China trade tensions, which could impact the value of the yuan, both offshore and onshore and drive investors back into the low-yielding yen.
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