The reflation theme... is it here to stay?
In the second half of 2016, the global economy embarked on a ‘reflation’ regime that has been impacting the investment environment ever since. This has been positive for risk assets as confidence levels improve.
One of the most important questions for 2017 is whether this bout of reflation will continue. My answer, in short, is no. Recent market optimism about reflation has been driven by commodity appreciation and president Donald Trump’s election victory, rather than a rise in core inflation (ex-food and energy prices). We therefore see this rise in inflation expectations as vulnerable, and as such are approaching it with caution.
Inflation expectations hit post-global financial crisis lows in February 2016, at a time when the price of oil was below $30 and the market had sold off on fears of Chinese currency devaluation.
At this time, the Bloomberg Commodity index also bottomed out, with the subsequent rally driven predominantly by energy and industrial metals. The former had been driven by a more sustainable market supply and demand dynamic, following a significant reduction in US production and the Opec freeze.
A high proportion of the increased demand in industrial metals can be explained by the huge Chinese fiscal stimulus package unleashed by Beijing in early 2016, coupled with a pick-up in property construction.
November then saw Trump secure victory in the US presidential election with a pro-business and anti-regulation rhetoric. The message from markets has been loud and clear: the reflation trade is on, with the Trump administration expected to deliver considerable stimulus.
However, the vulnerability of this reflation trade can be justified by a number of key risks.
Firstly, production of oil in the US has increased and the market looks to be oversupplied once again, causing further downward pressure on the oil price and in turn inflation. On the other side of the market, demand for industrial commodities has slowed with the Chinese government taking active steps to cool its burgeoning property market, thus reducing investment.
Finally, three months on and one legislative failure into Trump’s presidency, and we have no more clarity on what further policies he wants to employ or how he proposes to get these through congress. If investors lose faith in Trump’s ability to enact his pro-growth measures, expect to see a drop in inflation expectations.
When looking at market positioning, it is clear investors bought into president Trump’s agenda quickly, moving long US equities and short treasuries. The treasury positioning has come in a long way since, but the equity positioning continues to look stretched, suggesting that caution is required with equities.Given this, although inflation expectations are unlikely to return to the lows seen in February 2016, the risk is to the downside. As such, avoiding areas highly sensitive to changes in commodity prices or inflation expectations such as US equities, the FTSE 100, certain financials and Latin America appears sensible.