It’s taken little more than six months for the reflation trade to fall victim to the same valuation concerns afflicting a variety of other investments. Allocators worried that asset classes are overstretched are now starting to think the same about the overriding market narrative of recent times.
The strategy’s original investment rationale was simple: greater fiscal stimulus in developed economies would finally see the return of meaningful inflation driven not by commodity prices, or currency devaluation, but by an expanding economy. However, the chief political proponents have been reluctant to show their hand. The Trump administration has been fighting other battles, while the UK government is keeping money aside with an eye on Brexit, not infrastructure spending.
Hope has also been tempered by deteriorating data. Inflation expectations in the US are at their lowest levels of the year, and the personal consumption prices index has dropped for three months in a row. In Europe, eurozone inflation fell back from 1.9 per cent in April to 1.4 per cent in May. Only in the UK has inflation continued to rise, propelled forward by sterling’s slide.
“The risk is that the optimism around Trump reflation is misplaced,” says Ian Spreadbury, senior portfolio manager at Fidelity, at the start of last month, and it is a view that has gained credence since then: 10-year US Treasury yields are at their lowest levels since mid-November.
The counter-argument is that the reflation trade was premised not just on fiscal stimulus, but also better corporate earnings and a broader improvement in economic fortunes. Corporate profits have delivered their part of the bargain, and the eurozone in particular has shown signs of a return to health this year.
“US companies had their best quarterly earnings season in the first quarter since 2011. Elsewhere, the eurozone economic recovery appears to be well supported as credit growth recovers and business and consumer confidence remains high. China’s growth remains stable and Japan’s economy is benefiting from stronger external demand,” says Michael Stanes, investment director at Heartwood Investment Management.
Others, though, are less sanguine over the role being played by China, the country which has been more willing than most to turn to fiscal stimulus of late. Barry Norris, co-founder of Argonaut Capital, thinks the country is now reining in credit growth once again.
“The origins of reflation lay with a Chinese initiated global inventory restock which is likely to prove temporary. In the absence of Chinese stimulus, reflationary trades will likely continue to unwind with the sequencing witnessed in 2016: commodities return to a bear market; this feeds through to a deceleration in associated industrial production; and we see a continued flattening of yield curves on declining inflationary pressures, which depresses heightened expectations around a recovery in bank revenues,” he says.
A dip in commodity prices has been one notable market move this year, and another much-vaunted strategy has also struggled. Value funds’ return to form in 2016, given an extra boost by the emergence of the Trump trade, has shown little sign of continuing this year.
The FTSE World Growth index has returned 11.4 per cent year-to-date, but its Value counterpart has risen just 2.5 per cent, and the gap has been increasing in recent weeks. The switch has wiped out all of the relative gains made by the value index last year.
Other economists have started considering if the wrong type of inflation may now be more likely to emerge. Mr Trump’s lack of progress in the US means protectionist policies have been as hard to spot as his infrastructure plans.
But Neil Williams, group chief economist at Hermes, notes: “Should protectionist forces build, inflation would reappear with the possible exception of the US facing labour shortages, it will be the ‘wrong sort’ – cost-push, led by tariffs, weaker currencies, and goods shortages, rather than demand-pull.
“While reflation trades looked appropriate at the start of 2017, the spectre of protectionism, cost inflation, and dissipating growth may cause stimulus euphoria to fade.”
Absent that development, current conditions may just mean a return to a familiar, not unwelcome, pattern for investors. Mr Norris says that even renewed deflationary pressures coming from China may not “derail real economic expansion or cause a significant fall in general asset prices”.
The ‘goldilocks’ story so frequently referenced since the financial crisis – economies that are not too hot, but not too cold – may have a way to go yet.
