Growth Is Back With a Vengeance Vs. Value, So Is The Great Rotation Over?

At the start of this year, every sell side house and analyst was pushing the long reflation trade, essentially to be long cyclical stocks and sectors geared to the reopening of economies as they emerged from coronavirus lockdowns. The big shift out of growth and into value was pushed by a lot of people since that rotation began in earnest last November following President Biden's election. It was called a generational opportunity given 10 years of value underperforming growth, specifically technology, and most were eager to jump on that train and catch the momentum.

As commodity prices and hard assets rallied across the board in the first quarter this trade played out beautifully until it stalled around April. This was exactly the time when U.S. 10-year bond yields spiked to as high as 1.80%, spooking everyone that inflation was indeed permanent and not transitory. June has seen a near unwind of that trade with technology stocks up 10%-plus and value stocks down 15%, catching a lot of hedge funds by surprise as Federal Reserve Chairman Jerome Powell presided over a June Federal Open Market Committee (FOMC) with a slightly hawkish tilt.

Most hedge funds were teed up for Cathie Wood's famous ARK funds' downdraft as the main fund was down 35% in the first quarter, but it now has rallied 30% in the last few weeks. This was not based on fundamentals but pure top-down macro dynamics -- that is, if one believed inflation would be more permanent, then long-end bond yields would rise, which tends to be bearish for the technology sector. Because technology stock earnings are further out in the future, they are extremely sensitive to long-term rates. This was one of the main reasons why many hedgies were short technology stocks, the Nasdaq and Ark ETFs.

Credit where it's due, Cathie Wood stuck to her original themes of innovation, disruption and artificial intelligence (AI) and has been disciplined about adding to them each time they massively correct. This has proven to be a successful strategy time and again, to everyone's surprise. At least her message has been consistent. But what is really going on?

Since the FOMC meeting, U.S. 10-year bonds have rallied quite hard, catching most by surprise as yields were expected to go up, not down, if inflation really is not transitory. But given the record short positions in U.S. treasuries along with the Fed consistently buying $120 billion of U.S. assets every month, this has helped support the market.

One can suggest that the Fed has ruined what the U.S. long-end bond market stands for as it is no longer allowed to move freely. That said, yields are lower, and that almost symbolizes a deflationary feel to the market.

If that is the clue, then equities are just following suit as over the last few weeks the deflationary" stocks and sectors such as technology have rallied quite hard at the expense of all the reflationary cyclical sectors such as metals and mining and even oil and financials as the reopening trade has given up quite a bit. Is the market truly going through a deflationary shift here?

One of the biggest factors that caused a jump in all prices commodity-related has been China stimulating its economy to no end last year just to get it out of its slump. This caused a surge in prices across the board from steel and iron ore to lumber and consumer goods, which together with real supply chain disruptions added to an inflationary environment. The supply-side issues do not seem to be going away anytime soon as seen in container freight shipping rates and port inventories.

Since the fourth quarter of 2020 China has started slowing as evidenced by its negative credit impulse data. After all, it needs to get back to some sort of normality, especially as lockdown restrictions have eased and markets recovered.

Things such as used car prices, semiconductor shortages, lumber and construction all seem to be cooling off a bit, but even the Fed has thrown the towel in by saying this potentially could last a bit longer than it thought. We know the Fed has never been a reliable forecasting indicator as it always reacts than pre-empts. The market may be adjusting its inflated inflationary view slightly down a bit, but whether this is the start of a major reversal or a pause in value catching up to growth remains to be seen. One should ignore month- and quarter-end shenanigans as they tend to distort things a bit, especially when stop losses cause risk to be cut and positions unwound.