Last week the Federal Reserve raised interest rates and re-emphasised their view that rates will rise two more times during 2017. What surprised a great many commentators is that the dollar fell on the news. Ordinarily investors will find a currency more valuable as the interest that can be earned on deposits held in that currency goes up.
There were a few other market reactions to this news. Long-term interest rates fell. What this reflects is that short-term investors had become fixated about the prospect of higher inflation, higher interest rates and a stronger dollar.
These moves came about not because there was anything particularly downbeat about the Fed’s comments, but because they had been heavily distorted through speculation from short-term investors such as hedge funds and traders.
This has become wrapped up in the concept people call ‘the reflation trade’. This is an expression that essentially encapsulates what will happen if investors start to bet on higher economic growth and inflation.
The election of Donald Trump was seen as yet more vindication of that same theme (some people call it the Trump trade).
We tend to be sceptical of fads like this. There are lots of quite reasonable underpinnings of the investment stories the reflation trade promulgates, but there are others which are far wide of the mark.
When a large number of investors find themselves positioned for the same outcome it becomes mathematically more likely the opposite will happen. We are therefore a little sceptical about over-buying the US. While we are overweight the US in many of our equity portfolios, because we believe the growth story is strong, we also believe some investors are getting carried away.
News from America
That said, the news from America, which is at the epicentre of the reflation trade, is good. Citibank produces a well-followed index of economic surprises, which is at its highest since 2013. The index rises when economic data exceeds the economic consensus forecasts, and this tends to support equities.
In addition, inflation is indeed rising, but a lot of this is to do with the fact that energy prices have more than doubled since this time last year. Underlying inflationary pressures are present, but wage growth remains fairly modest. What matters more than the trends in growth and inflation are the drivers of those trends.
The global economy has seen a coincident improvement in economic performance. To identify this as being a result of the change in US president requires a huge leap of imagination (especially when some of the president’s rhetoric is antagonistic towards other countries).
The improvement is in fact due to a big boost to real incomes (that is, incomes that have been adjusted for inflation). Because oil prices fell so much between 2014 and 2016, thereby reducing inflation, consumers’ disposable incomes rose.
Because oil prices have risen again since last year, that pace of disposable income growth has fallen back to nil. Make no mistake, oil prices are still around half of what they were two years ago, so consumers and non-oil related businesses should be enjoying a joint benefit. But the impact is a little less than it was last year.
With that in mind, while we remain positive on the pace of US economic growth and its impact on equity markets, we also think there is excessive enthusiasm for certain aspects of the reflation trade.
What strikes us at the moment is that there appears to be more value in areas that are not quite so heavily trodden by the investment crowds, such as Europe, the Far East, or indeed here at home in the UK.
Guy Foster is group head of research at Brewin Dolphin.