It’s far too early to write off the global reflation trade
Is the much-hyped reflation trade fizzling out?
Over the past month or so, a flurry of economic data and market indicators have convinced many strategists that the nine-month-old repositioning of investors’ portfolios in anticipation of stronger growth and inflation has lost considerable momentum, and may even be about to peter out.
The facts speak for themselves.
Commodity prices, the fuel for the reflation trade, are once again under strain. Last week, oil prices suffered their sharpest weekly fall since early March, partly due to a rebound in US shale production. Brent crude, the international benchmark, has dropped 7.5 per cent since April 11 to US$51.90 a barrel.
Other commodities are also under pressure. The price of iron ore, a key ingredient in steelmaking, dropped to a six-month low last week while the price of copper, another key export for some emerging markets (EM), is down 10 per cent over the past month.
Not surprisingly, this is contributing to the recent decline in inflationary pressures. Bond market expectations for US inflation over the next five years have dropped to their lowest levels since last December.
In the euro zone, the core, or underlying, inflation rate – which was already less than half the target of the European Central Bank (ECB) at the start of 2017– fell to just 0.7 per cent last month, while in China, producer prices have started slowing.
The odds of the Federal Reserve raising rates for a second time this year at its meeting in June have dropped to roughly 45 per cent, from 60 per cent at the beginning of April. This is helping push up the prices of government bonds, with the yield on 10-year US Treasuries falling nearly 40 basis points since mid-March to 2.2 per cent.
According to Tradeweb, a bond trading platform, the stock of European and Japanese debt trading at negative yields is rising again.
Even more tellingly, US equity funds, the greatest beneficiary of the reflation trade -- because of hopes that the new administration of Donald Trump will deliver a hefty domestic stimulus package -- have begun to suffer sharp outflows, with US$14.5 billion in redemptions in the week to April 5, according to EPFR Global, a data provider.
What is perhaps most concerning is that the prospects for the US economy are not as bright as previously thought.
Over the past month or so, market commentators have pointed to a worrying disconnect between so-called “soft” economic data (readings associated with household and business confidence) and “hard” data (statistics derived from real economic activity).
The soft data has improved markedly since Trump’s victory, with a surge in optimism among small businesses and a sharp increase in consumer sentiment to a 17-year high.
However, the hard data has, for the most part, been disappointing. Manufacturing activity and retail sales fell last month, while corporate investment remains flat.
On Friday, the publication of first-quarter gross domestic product data for the US economy is likely to show that growth slowed to as little as 0.5 per cent, although partly due to unusually warm weather in January and February.
All this suggests that investors have been overly sanguine about global reflation. It does not, however, mean that the reflation trade is well and truly over.
While US equity markets have been declining over the past several weeks, the correction has been a small one. The benchmark S&P 500 Index is down less than 2 per cent since early March and is still up nearly 10 per cent since Trump’s victory.
Global stocks, moreover, are trading at near record highs. According to the latest Global Fund Manager Survey published by Bank of America Merrill Lynch last week, investors have started pouring money into euro-zone and EM stocks, mainly because of more appealing valuations, but also because of improving prospects for growth, particularly in Europe.
The survey also notes that, despite mounting concerns about Trump’s ability to win Congressional approval for his pro-growth policies, more than 40 per cent of respondents still believe his administration will be able to pass some type of tax reform by the end of this year.
Markets have not yet lost faith in the reflation story.
Indeed, even the International Monetary Fund is sounding more optimistic about growth. In its latest economic outlook published last week and entitled Gaining Momentum?, the fund expects global growth to pick up to 3.5 per cent this year, up from 3.1 per cent in 2016.
As is often the case with markets, excessive optimism has given way to undue pessimism.
The reflation trade may still have legs.
Nicholas Spiro is a partner at Lauressa Advisory