Waiting for confirmation on reflation

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Reflation can be seen clearly in a number of indicators around the world. Producer prices in China have surged from – 5.9% year on year (YoY) in December 2015 to 6.9% this January. Chinese producer prices are highly correlated with commodities. Over the long term, the correlation between the GSCI commodity index and Chinese producer prices is 87%, with commodities leading producer price trends by two months. Thus, the change from falling commodity prices to strong price gains in the last eleven months partly explains developments in the Chinese producer prices index (PPI). But, based on their past relationship, Chinese producer prices have now moved ahead of the levels that commodity prices would project. Taking the two-months lag into account, the 11.9% YoY gain in commodity prices of last November would suggest only a 1.5% YoY gain in Chinese producer prices in January. As said, the actual gain was 6.9%.

Exhibit 1: Commodity prices and Chinese PPI

reflation

Source: Bloomberg, BNP Paribas Investment Partners, as of 27 February 2017

Base effects (that is, a very low rate of inflation a year ago) may play a role and inflation is strongest in upstream, commodity-related industries, but we see this as a sign of reflation. Elsewhere in Asia, South Korean producer and export prices, which are less sensitive to commodity prices, have also moved from deflation to inflation, while producer prices in the US and the eurozone have started to increase.

Higher inflation would in theory be positive for equities at this stage. It would enable companies to increase selling prices, margins and thus profits. Higher bond yields could have a dampening impact on equities through a lower valuation, but based on historical relationships, yields are currently too low to be optimal for equity valuations. Yields at current levels reflect too much uncertainty about geopolitics, growth and inflation, in our view.

Reflation: much discounted in the markets

In our opinion, markets have, over the last few months, largely discounted the reflation trade. Equities in all major regions have rallied since the US election. Credit spreads have generally fallen towards the lowest levels since the financial crisis, although they have widened for investment-grade corporate bonds in Europe. European investment-grade spreads had been strongly supported by the ECB’s asset purchases, but the discussion about the ECB tapering its purchases has caused some widening. Bond yields rose sharply last November and then moved sideways before a recent decline to the low end of the trading range since November.

We see headwinds for the reflation trade. The first is the fact that it’s obviously now widely discounted. The second is the observations that inflation has not shown up everywhere. Core producer prices in the US (stripping out food and energy prices) had remained muted but the Fed’s preferred measure of inflation, the core personal consumption expenditures price index (PCE), climbed 0.4% in January, according to data published by the Commerce Department on 01/03/17, that’s up 1.9% from a year ago, close to the central bank’s inflation target, after hitting 1.6% in December. Core PCE, which excludes more volatile items, rose 1.7% year-on-year. This latest uptick in inflation is one of the factors that bolstered the case for the Fed to raise interest rates this month

Meanwhile, in the eurozone core consumer prices have been below 1% for 10 straight months and the ECB has signalled that it is willing to look through the temporary impact on headline inflation of higher energy prices.

Wage inflation is only showing up in the US. But even there it is much lower than the tightness in the labour market, as indicated by the unemployment rate, would suggest.

Finally, most of the inflation that we currently see is driven by the rise in prices of commodities; higher oil prices in particular. This is not the type of inflation that would be beneficial. It actually increases costs for companies and for households.

Late-cycle reflation: good for equities?

Adjusted for inflation, wages are hardly growing in the US and Japan. Consumer confidence slipped in the US and the eurozone in February, albeit from high levels.

Exhibit 2: Consumer confidence in the US and the eurozone fell in February reflation

Source: Datastream, BNP Paribas Investment Partners as of 27 February 2017

Any indications of the negative impact of rising energy prices on consumer spending are nonetheless something to watch our for. On the relationship between equities and interest rates/ bond yields, things may be different this time in the US. Normally, equities rise when the Federal Reserve raises interest rates and bond yields increase. But this typically happens in the early stages of the economic cycle when profits recover from a growth slowdown or recession. In such circumstances higher profits more than compensate for a compression in price-earnings ratios. Currently the US cycle is much further advanced, so the room for profit expansion looks much more limited.

Political uncertainty is still high. Last week US President Trump unveiled his fiscal plans, but it remains to be seen how much detail and clarity will be given. And will Congress play along if there is a big budget deficit in the plans? Will there be any indications of protectionist measures? It now seems that the infrastructure spending plans have been moved to 2018. In France independent presidential candidate Emmanuel Macron’s chances of getting through the first round of the elections have risen. French government bond spreads versus Germany narrowed, although spreads in France, Italy and Spain are still somewhat above the levels of the past few months.


Written on 6 March 2017

Joost van Leenders

Chief economist, Multi Asset Solutions, CFA charterholder

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