Jan. 11, 2022

What happened to
the reflation trade?

Guest: Derek Smashey, CFA, Co-Portfolio Manager at Scout Investments

In this episode of Markets in Focus

During the gold rush, the real money was made not by miners but by the businesses who sold the miners their picks and shovels. Now semiconductors are poised to be the picks and shovels of the coming decade, said Derek Smashey, CFA, Co-Portfolio Manager at Scout Investments. Smashey joins Matt Orton, CFA, Chief Market Strategist at Carillon Tower Advisers, to examine what happened to the reflation trade over the last year and what to watch for in 2022 and beyond.

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Matt Orton:
Well, it might seem like the distant past. It was just over a year ago that we received the positive news around strong vaccine efficacy in combating COVID-19. And this news dramatically changed the trajectory of equity markets. Bigger companies and growth companies had dominated most of the recovery rally, but the vaccine news sparked a renewed enthusiasm around economically sensitive parts of the market with cyclicals rallying and The Russell 2000 posting its strongest quarterly performance on record. Rates also bounced sharply and provided further investor enthusiasm for sectors that had dramatically underperformed like financials, but rates have since stalled, small caps until pretty recently have been moving sideways for the better part of eight months, and growth is again outperforming value as many of the more cyclical sectors have underperformed the broad market. I know I'm not alone in asking what happened to the reflation trade?

Today I'm joined by Derek Smashey, co-portfolio manager at Scout Investments, and he looks specifically at mid-cap companies and also covers sectors that I would characterize as having both cyclical and secular growth drivers, which is why I'm especially glad to have him join us for this discussion, which will look at the reflation trade and identifying some opportunities going forward.

This is Markets In Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. Derek, thanks for joining us today.

Derek Smashey:
Hey Matt, thanks for having me.

Matt Orton:
Of course. In going back to my opening remarks, maybe a great place to start is to get your thoughts on the current state of the reflation trade. We've seen some mixed economic signals and seen some data, and we've seen inflationary pressures that might not be so transitory. So given that the backdrop, I would say, is a little bit less clear than it was at the beginning of the year, doesn't it make sense that we've seen the reflation trade lag a bit? And do you think are still legs for it to outperform heading into 2022?

Derek Smashey:
Yeah. That's the big question. So there are multiple doors that we could go through as we enter the new year. One of which is the reflation trade resumes its leadership that we saw in the fourth quarter of 2020 into early 2021. The other is what we've seen more recently over the last couple of quarters, which is growth just continues to do well. One thing that isn't as widely considered, but I think we need to factor in, is what happens if the Fed tightening and just the lack of stimulus relative to what we saw during 2020 and early 2021, what if that leads to a little bit of a slowdown and perhaps there you may need to get more defensive, or you may need to focus more on quality.

So there are a lot of different options clearly to the extent that you can get that call right, I think that's really going to drive performance into the next year. But just stepping back, I think big picture is we're arguably in unchartered territory here. There are a few historic parallels to the current environment. Clearly we are still fighting through the pandemic, which, of course, led to significant monetary and fiscal stimulus. We're going through a bout of significant inflation. Looks like it's the highest inflation we've seen judging by the CPI in 30 years.

And the other factor that's really interesting is this inflation looks more demand-driven instead of supply-driven. So if you look back to the 1970s, which perhaps would be a playbook, that seems that it was more driven by supply factors rather than demand, which stayed relatively stable through that time. Whereas now, because of all the stimulus and because people were locked up, they had to stay home, they were spending money on goods and that created a lot of problems with the supply chain, and clearly we're still working through that. So in our opinion, this is uncharted territory. So the question is, okay, where are we? And big picture, so longer term we're asking ourselves, are we in a new regime? Is this the start of something new? And we talk about, internally we talk about scarcity versus abundance. And these cycles can go 10, sometimes 15 years. And you tend to go back and forth, or another way to describe it would be a classic commodity cycle.

So when you get into a situation where there's higher scarcity, commodities tend to do well, when commodity prices are heading lower, when there’s so called abundance, you tend to see growth stocks do well, rates tend to be lower. That's a question that we're asking ourselves is now that we're coming out of this pandemic, and we're seeing a lack of supply with a lot of various commodities because of the lack of investment over the last five plus years, are we entering a new regime? Something maybe similar to what we saw in the early 2000s when we saw the ascendancy of China and all that incremental demand with things like oil, a lot of base metals, things like that.

So that's the big picture question, but to answer your specific question on reflation and looking into 2022, while there aren't great parallels, we can clearly look back to what drove that trade in the fourth quarter of 2020 and into 2021. So if you look back all the way to the pandemic, clearly everything sold off in March of 2020, the Fed came in aggressively, the federal government, both in the US and outside the US, stimulated aggressively. So everything bounced back at least at first, but then it wasn't long, and we all realized that, look, this pandemic isn't going away anytime soon. So then the stocks that typically depend on a stronger economy, a so-called reopening, they just lagged through the summer of 2020. The interest was more in growth stocks, companies that were going to benefit from digitization, benefit from people spending more time at home, or maybe on their phones, they just had more free time, because you really couldn't travel, do things like that.

So we saw those types of stocks work through the second and third quarter of last year, but then as we got into the fourth quarter, and it's really interesting how the mindset shifted along with the calendar. And frankly, we see that quite often. So as the calendar shifted in the fourth quarter, the market was starting to anticipate that we could get some positive vaccine news. There was room for the ISM Manufacturing Index to move higher. Of course, valuation spreads were really wide because growth had outperformed value significantly up until that point. Credit spreads were moving lower. And, of course, there was this reopening trade yet ahead, because we really hadn't reopened the economy into the fourth quarter of last year.

And, of course, things ended up being even better than expected. The vaccine news that came out from Pfizer, the efficacy was a lot higher than we all expected it, well over 90%. That provided the initial surge for the reflation trade. We got past the presidential election. Anytime you can just check something off the box, it reduces uncertainty in many cases, regardless of the outcome, it's just the fact that you have a more certain environment that certainly supports the markets. So in addition to that, of course, Biden was able to easily pass a massive stimulus bill soon after he took office. There was just a lot of tailwinds at that point that drove that reflation trade in the fourth quarter and first quarter of 2021, which, of course, it eventually sputtered out. Who knows for sure why it sputtered out? But clearly one of the things that happened was interest rates moved significantly higher and they were much wider in the US relative to other major countries. We think that probably had an impact.

The other thing, of course, is by the time we got into May or so of this year, the market really started to believe that the Fed was going to be extremely patient, they were calling inflation transitory, and the fact that there was a lot of liquidity that was going to remain in the market once again led to growth stocks starting to outperform. So here we are almost exactly a year later from when the reflation trade started. So we have to ask ourselves, okay, where are things similar? Where are things different? Well, one area where it's similar is certainly in terms of valuation. So if you look at the total return of the Russell Growth Index (Russell 2000 Growth Index) versus the Russell Value Index (Russell 2000 Value Index), we are right back to the highs we saw a year ago. If you look at PEs, or price-to-earnings ratios of growth stocks versus value stocks, they're actually higher than they were a year ago.

So you can certainly say, hey, from a valuation standpoint, it's supportive of this reflation trade. But if you look at the fundamental drivers, then it's not so clear to us. So for example, the yield curve had plenty of room to move up. And in fact, the yield curve started climbing significantly in the fourth quarter. Now, what we're seeing is yield curve flattening. If you look at credit spreads, credit spreads were relatively wide and there was room for them to narrow, which they did during that time period. Now credit spreads are at all-time lows frankly. So there just isn't much room for them to go lower. And, in fact, more recently we've seen those credit spreads start to widen a bit. And then COVID, we're obviously a year past, we've had vaccines around for a long time. Now we're getting news that we have some antiviral pills that should be approved soon. So, that's pretty exciting. So there's probably a little bit more left in terms of reopening the economy, but not near as much as what we had in front of us late last year.

PMIs have probably peaked, that's something else to consider. And then, of course, the Fed is tightening, reducing liquidity from the market, slowing down our quantitative easing, and the market is starting to factor in higher interest rates as we move into perhaps mid 2022. So a little bit sooner than what we anticipated even a few weeks ago. So from a fundamental standpoint, I don't think the case is all that strong for a reflation trade, from a valuation standpoint it is interesting. And we could certainly see a little bit of a bounce in those types of stocks, which I would classify as probably energy, materials, certain financial stocks certainly fit the bill, and certain industrials just to give some examples. So our thinking is you probably want to be selective at this point. There are pockets that we find really interesting that would fall into the reflection trade, but it's just too far into the cycle. The fundamentals really don't support it. So we would be more stock pickers right now, rather than going all in on a reflation trade.

Matt Orton:
Great. I appreciate all of that background and insight Derek. And I think one thing that you mentioned before that I think fits into maybe another good discussion point is quality. You had mentioned quality and we're finally starting to see more quality companies perform better. You talked about selectivity, which I fully agree that I think selection's going to be very important going forward. So as you think about the whiplash you've had between growth versus value, and where we stand right now with growth outperforming, as a core manager when you look across both types of companies. What opportunities are you finding right now? And I'd say more on the quality side, are there opportunities to get exposure to more quality companies, both in growth and value?

Derek Smashey:
I really like that question because that's where we see the most opportunity. And frankly, it looks like we're in mid-cycle. So you come out of a recession, you're an early cycle. You expect the cyclicals to outperform, but sooner or later, you don't have as much stimulus from the government or from the central bankers. And at some point quality starts to make sense when you're in the middle of the cycle, which it certainly feels to us like that's probably where we're at. The challenge is the market has certainly identified a lot of those higher quality companies and they've been bid up, but with interest rates low, like they have been and likely will remain for some time, you can support those, which again, just have to be a little more selective, but in terms of where we're spending incremental time, we certainly think maybe you don't focus so much on growth or value, but perhaps it makes a lot more sense to focus on quality.

And that's where we're spending a lot of our time right now, that's where we certainly see a lot of opportunity. So absolutely, we think quality companies, so how do you define a quality company? You typically want a company with a higher return on equity. You like to see strong margins, especially in this environment where pricing power is so important. And companies with higher margins almost by definition have pricing power. We certainly prefer companies that don't require as much labor, because labor costs are going up. So if you can find companies that are less reliant on labor, that have real pricing power, ideally they have really strong positions within their markets. We like to see those companies that are gaining market share, especially in very large markets. We find those types of stocks to be especially attractive at this point in the business cycle.

Matt Orton:
Great. And I think to take that one step further, I've been very optimistic about the ability of companies with exposure to strong secular growth drivers to continue to outperform, and I think a lot of these fit into the more quality segment, and I noticed that you have exposure and a lot of optimism, it seems around some tech-enabled themes like AI, machine learning, 5G communication, software as a service, automotive electronification. Maybe you can share why you're excited about these long term themes, even if valuations look lofty?

Derek Smashey:
Yeah, that's a very fair question because there's been so much liquidity in the markets and interest rates are really low. That's one of the reasons why these really innovative companies have been bid up, but there's a little bit more to it and it has to do with market size. So unlike maybe a decade or two ago, if a company comes out with a really special product or service, they can grow at internet scale. They can tap literally a global market in many cases. And it's just breathtaking how quickly these companies can get to, let's say it's a startup, get to 10 million, or a hundred million of revenue, or let's say it's a well-established company like some of the FAANG stocks. It's amazing how despite many years of growth, and very large top lines, ie, revenue levels, they continue to grow at double digits, and it's because it's a really big market. And when you have something special to offer, you can continue to grow for many, many years.

So we think that's something you have to factor in when you're thinking about these higher valued growth stocks. Oftentimes not only factoring in the lower interest rates, but the fact that the growth can be sustainable for many, many years. I think that's something that near term price to earning ratios, or price to sales ratios may miss. So let's say that the market is baking in 30% growth, and then the typical ruler analysis where, okay, the next year it's 25, the next year it's 20. And the models just gradually decline. Well, if you look at history for a lot of these companies, especially the ones that are successful, the ones that are gaining market share and are in large markets, oftentimes what you see is they’re able to sustain high growth rates, whether it be 30, 40%, whatever that top line growth is, for many more years than is typically anticipated.

So, from a valuation standpoint, that's how you can get comfortable with owning those stocks. But setting that aside, the question on owning innovative companies, there's no question that if you're in my seat, I spend a lot of my time looking at technology stocks and it's hard not to be optimistic if you pay attention to what's going on. Obviously artificial intelligence is something a lot of people talk about, Web 3, or cryptocurrency, blockchain technology, whatever you want to call it. One of the latest interesting terms that's been thrown around, I've been following this for several years now, but it's really coming into the mainstream is this metaverse concept. So it's going to be a really interesting decade. I've heard people call it the roaring twenties. It's going to be really fun to see, how, what does everyday life look like in New Year's Eve of 2029?

And just to see, how are we living our lives at that point? Because I think a lot is going to change over the next 10 years, but the question is, okay, that's really interesting from a technological standpoint, but okay, how do you invest? One of the areas that we like to invest in is, especially in mid-caps this makes a lot of sense, is to invest in the picks and shovels, or the productivity enhancers. So you probably recall from the gold rush in the mid 1800s, the gold miners that, the prospectors didn't necessarily make the money, the real money was made in selling picks and shovels and blue jeans to the miners. So we really like that idea in our space, and midcap is a great area that you can take advantage of that idea.

So one concept that's really interesting. So Marc Andreessen, he's is really famous venture capitalist. He invented the first web browser. And he wrote this article several years ago that was titled, software is going to eat the world essentially. There's a really interesting quip on that from a analyst that I follow on Substack, he says, "If software is going to eat the world, semiconductors are the teeth."1 So we really think semiconductors, from a long term perspective, are really interesting area to invest in. One area to do that, getting back to this picks and shovels idea, is in semi-cap equipment. So in that case, you're benefiting from the increased use of Silicon in all areas of life. So whether it be electric vehicles, autonomous vehicles, obviously that's going to require a lot of computing power, industrial automation, this metaverse concept, if we're all going to be spending some of our time in virtual or augmented reality, that's going to require a lot of computation.

AI is especially interesting, or machine learning. There's a really interesting chart that's been making the rounds for a couple of years now. And if you look at the state-of-the-art natural language processing software, or this neuro network, if you will, if you look at it back to the 1960s, it very much followed the trend of Moore's Law. Moore's Law says that basically every two years or so, you double the amount of computing power. And you saw that trend very steadily all the way until the early 2010s. So around 2012, 2013, there was this huge ramp in these natural language processing networks. And what happened is we realized how to actually make AI work, and use these neural networks, if you will, to enable that. Well, that requires a lot of computation power.

So if Moore's Law was doubling every two years, these neural networks are doubling their parameters, or their computational power, every three to four months. Well, you can certainly imagine in an environment like that, you're sure going to need a lot of semiconductors. Now you're still going to see cycles. We haven't repealed the business cycle. We haven't repealed the economic cycle, but if you look long-term, if you look through those cycles, we think semiconductors are really interesting. We think semi cap equipment companies specifically, they're the ones that provide the equipment to make the semiconductors are really interesting. Not only because of all the factors I just mentioned, but also because you're seeing capacity being added around the world. As it turns out, most of the leading edge semiconductors are produced in a little island right off the coast of China, Taiwan, of course. And for national security reasons, most politicians are coming around to the idea that that just doesn't make sense.

So you could argue semis are the new steel, where everyone needs to have their own native semiconductor capacity. So we think you're going to see a lot of capacity added in places like the United States and Europe and India and countries that, if something were to ever happen where we didn't have access to that production that comes from South Korea, that comes from Taiwan, we would still have the means of innovating and staying at the cutting edge. So if software is going to eat the world, semiconductors are the teeth. And that's an area that we think is, that's the foundation, if you will, of all this innovation that we see over the next decade plus.

Matt Orton:
I love the analogy Derek, and I think as you look at the semi space, given that we're talking about reflation, inflation, a natural question then is given the supply chain issues that we're having, given some of the inflationary pressures we're seeing around labor, factories being shut down, how has that impacted some of the different parts of the semiconductor market, and how do you assess that impact going forward when you're picking potential investment opportunities for your portfolio?

Derek Smashey:
Yeah, it's certainly had an impact, and some companies have done a better job than others of managing the challenges. It's interesting that when we look at our management teams that we've always considered to be best of breed management teams, they've been able to manage through it. And whether it's because they have a really strong market position, so maybe they're first in line at some of the fabrication facilities. So, they're getting their chips when others aren't, or they had enough foresight to build inventory levels well ahead of time, so that they've had inventory right now, or they're just long-term focused and they're not afraid to build excess capacity in spite of the fact that maybe that hurts your margins in the near term. So some of these companies based in Asia perhaps were building capacity because they knew that there was a path to significant long-term growth. And lo and behold, when the supply chain issues popped up, they already had capacity online.

So the better companies are managing through it, but clearly it's still a challenge. It doesn't look like it's going to be resolved anytime soon. From my understanding, the finished goods are there, they're just sitting in warehouses. So they're sitting in a warehouse somewhere over in Southeast Asia, or perhaps they're on a boat somewhere, or they're sitting at a port out in California. So the finished products aren't really the bottleneck, it's mostly the freight piece. So it's the oceans, so it's shipping containers, that's primarily the issue. We're starting to see headlines that the worst, maybe behind us, we're seeing the ports are starting to clear up a little bit. We're seeing that empty containers are now starting to get shipped back to China. We're seeing that some of the areas, perhaps like in Southeast Asia that were shut down because of a COVID wave they're back to work.

So the worst is probably behind us, but we think demand is going to remain strong. We think it's going to take a long time for supply to catch up. So our bet is that inflation is going to be with us, whether it be in semiconductors or other areas of the economy for quite some time. But we probably won't sustain 6% plus CPIs for a substantial period of time, but with semiconductors specifically, it's certainly been an issue. We factor that into our analysis, but frankly, the best management teams, again, they're managing through it. And if you look beyond the next several quarters, we're really excited for some of those growth opportunities.

Matt Orton:
And Derek, I think we've got time for about one more question and you talked about inflation and I always like to ask what some of the potential risks are to an upside scenario, or the optimism that I think you and I both share going forward. So, what do you think could be, or might be some of the biggest potential risks going forward into 2022 that investors should be aware of and that you are thinking about and managing through in your portfolio?

Derek Smashey:
Well, I don't think many are at the point where they think, okay, maybe we're going to see some trouble, maybe it's time to get defensive. That's an outlook that we probably need to spend more time on collectively as a group, whether it be our team as money managers, or other professional investors. So we certainly need to at least examine that possibility. Now that's not our base case. It certainly feels way too early to get defensive. We don't see a lot of excesses in the economy, so we don't think that's the way to position the portfolio, but that would certainly be out of consensus. So I think that's one of the biggest factors is okay, the Fed is starting to reduce liquidity. So it hits the most speculative parts of the market first, we're already starting to see signs of that. Although the speculation hasn't completely played out as exhibited by just one example, the electric vehicle stocks and seeing where some of those are valued and they continue in some cases to receive a bid.

So, all that speculation hasn't completely been wrung out of the market, but as the Fed reduces liquidity, you would expect that trend to continue. On the flip side as we're raising interest rates, if the long end of the curve can't move up because long-term growth expectations aren't moving up as well, then you're just going to see the yield curve flatten. So the short end of the curve may move up. If the long end of the curve doesn't move up in tandem, you may start to see the yield curve flatten. Historically, once it inverts, you've typically experienced a recession within a matter of months from that point. So that's something we would keep our eyes on is if, frankly if we just don't see a lot of growth next year harmed partially by a lack of stimulus, certainly we've got an infrastructure bill that just passed and that's interesting, but at the end of the day, an incremental 550 billion over 10 years, it's just not going to move the needle that much in a $21 trillion economy.

We certainly are in support of spending on infrastructure and think it's needed beyond even roads and bridges. We think building out the internet, building semiconductor plants, building ports. There's a lot of things that we could spend capital on that we think would be net present value positive, but who knows if the Build Back Better plan will get passed or not, we're a little bit skeptical. We'll see how that plays out. But with less stimulus, with the Fed tightening, that would the one risk factor that I would just share is that maybe we're further along in this business cycle, because it seems like these cycles accelerate faster than ever. And if maybe we're further along in the business cycle, then we appreciate there may be some downside risk. So that's something to think about again, that's not the base case, but that's something that we are at least considering.

Matt Orton:
Perfect. I appreciate those comments, and I would love to continue this conversation and revisit where we stand if we check in maybe earlier in 2022, but I certainly appreciate your time Derek. This has been a great conversation and thank you to all of our listeners for tuning in, and until next time, take care. Thanks for listening to Markets In Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.


1 Original quote from Kif Leswing.

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