Risks around the reflation trade

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US, European and emerging market equity markets have had a strong run recently suggesting that markets continue to anticipate stronger economic growth and rising inflation.

However, the recent fall in oil prices, a flattening of interest rate yield curves (see Exhibit 1 below) and some aspects of sector performance in stocks (e.g. the underperformance of basic materials industries in US stocks and outperformance of telecommunication stocks in the US, Europe and emerging markets) suggest the emergence of doubts about the faith in a reflationary trend.

Exhibit 1: Doubts about reflation ? – Interest rate yield curves have flattened recently in the US and Europe, this may reflect downward readjustments in bond markets of the expected future rate of inflation

reflation

Source: Datastream, BNP Paribas Investment Partners, as of 20/03/17

 Uncertainty over the prospects for US fiscal stimulus is rising

The prospect of the launch, by the new US administration, of a major programme of fiscal stimulus was an important element of the expectation that reflation was on the way. But, US health care reform is progressing slowly and on 13/03/17 it was dealt a blow by a report from the Congressional Budget Office (CBO) concluding that 24 million more Americans would be uninsured under the new as compared to the current Obamacare legislation. In addition, premiums would likely rise for groups that need most assistance with health care costs. The administration was quick to dismiss the CBO’s findings, even though the conclusions that average premiums would fall and federal cost would be lower under the new proposals were positive for the Republicans.

Nonetheless, with Democrats fundamentally opposed to the proposed changes, some Republicans concerned about the CBO findings and other Republicans arguing for even stronger reforms, the fate of the new proposals is very much up in the air.

While important in itself, the main question this raises is whether or not it will impact the timeline for  US tax reform. Although it may not necessarily mean delay, expectations for tax reform have moved backward. We think tax reform may still be discussed before the summer which would mean it could be implemented in 2018. However, all this is somewhat disappointing when set against the high expectations for bold and rapid change shortly after the US elections.

And of course there is the risk of protectionism

It was apparent at President Trump’s first meeting with German Chancellor Merkel on 17/03/17 that  they have different views on the merits of free trade. This was confirmed at the meeting of the G20 finance ministers in Germany where the agenda focused on the common strategy of free trade, financial regulation and climate change. In other words it was clearly the US versus the rest. As a result the mention in the communique of a commitment to fund action on climate change was dropped. The reiteration of warnings against competitive devaluations and disorderly foreign exchange markets should be seen as positive, but the failure to agree on a commitment to keep global trade free and open was clearly negative. The powerful statement that “We will resist all forms of protectionism” was dropped from the communique.

Despite the  rate hike in the US on 15/03/17 and the hawkish signals in the eurozone yield curves have flattened in the week through 20/03/17 (in the US two-year yields fell by 3.5 basis points, but ten-year yields fell by 7.4 basis points while German two-year yields gained 2.8 basis points while ten-year yields slipped 5.9 basis points). The moves in bond markets are relatively small and for ten-year yields in the US and Germany they are within the range seen in the past months. Furthermore, two-year yields in the US had moved above their recent trading range before the Federal Reserve’s meeting on 14 – 15/03/17, driven by a plethora of Fed hints for a rate hike.

In the the German bond market two-year yields have just recovered from a trough in late February, but are still firmly negative and close to record lows. This all argues against reading too much into the curve flattening, although its significance increases as it is not what one would have excepted under the circumstances given central bank actions and comments.

For equities this may become a headwind at some point. For the time being we still consider monetary policy to be a positive-to-neutral factor for equity markets. We do however think that market are priced for perfection:  that is, stable but positive growth, modest inflation reflected in low interest rates. We see equities as expensive on current valuation measures. Taking into account our forecasts for growth, inflation, rates and earnings we don’t expect this to change. Hence our underweight in developed equity markets.


Written on 20 March 2017

Joost van Leenders

Chief economist, Multi Asset Solutions, CFA charterholder

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