We are nearing the anniversary of a great market turning point. Like most such turning points, it was not obvious as such at the time, but in early July last year markets reached the lowest point of their fear of deflation — falling prices amid a stagnating economy — and started to position for reflation.
The shock of last summer’s Brexit referendum brought bond yields, the market’s most direct expression of its belief in deflation, to a historic low. The rebound started as the effects of China’s economic stimulus were felt, while it grew clear that Brexit had not sparked a financial crisis.
It gathered momentum after Donald Trump’s victory in the US presidential election. The theory was that the Trump administration would pick up the baton from China, which looks over-leveraged and will soon need to ease off its stimulus, and would bring in its own growth-friendly policies, including tax cuts and infrastructure spending. From “reflation off”, we moved emphatically to “reflation on”.
Stock markets have risen this year, but 2017 has seen a gradual shift back to “deflation-off”. Short-term inflation expectations have moved sharply in recent weeks. The bond market’s implicit forecast for US inflation over the next two years, once at 2.15 per cent, has dropped to 1.35 per cent. Why has this happened?
The oil price is vital for short-term inflation, as oil costs make up a large part of the price index. Crude prices have fallen recently. But the move in inflation forecasts goes beyond what can be justified by the reduced oil price: 10-year break-evens, stable at 2 per cent for several months and theoretically unaffected by short-term oil moves, have also dipped below 1.9 per cent
Another driver of deflationary sentiment is economic data. After months of pleasant surprises, the data are no longer running ahead of expectations. Citi’s US surprise index has dropped precipitously in recent weeks, to return close to where it was on election day.
And of course there is the Federal Reserve. Higher interest rates buoy the reflation trade, and early last month the Fed seemed determined to raise rates at least three times this year. But once it announced last month’s rate rise, the Fed started to sound more ambivalent. In combination with the cooling economic data, that sent the implicit market judgment of the odds of three rises this year tumbling, from 60 to 40 per cent (even after a pick-up this week when the president of the Dallas Fed said that three rates was “still a good baseline”).
Finally, of course, there is politics. Approaching the end of the president’s first 100 days, a big fiscal boost no longer seems the given that it once did.
What will determine whether the reflation story wins out?
Alain Bokobza, Société Générale’s chief investment strategist, suggests two critical triggers. First, there is the oil price. If, as he predicts, oil stabilises at a slightly higher level of $50-$60, then inflation expectations will rise again, and nerves will be soothed.
A second trigger is policy. Last month’s defeat for Mr Trump on healthcare reform dealt a severe blow to the idea of a big fiscal stimulus, but it the US administration can piece together a meaningful tax cut and a way to pay for it — and this ought to be possible before the year is out — then confidence in the reflation trade should come back. Thursday’s rebound in rate expectations had much to do with a few words from Steven Mnuchin, the Treasury secretary, who said that a tax reform plan would “soon, very soon,” occur and be “sweeping,” reversing his previous attempt in an interview with the Financial Times to dial down hopes for tax cuts.
Against this, the White House decision this week to start a process that could lead to new steel tariffs, along with Mr Trump’s public complaints that the trade policies of Canada, the US’ friendly neighbour, were “taking advantage” of US farmers, shows that rising protectionism remains a real possibility. That would be regarded as growth-unfriendly.
So the market is retreating into a “reflation-off” position, but a rise in the oil price and some US tax cuts, both plausible, could swing the dial again. How should investors respond?
Reflation affects almost every asset class. Within the stock market, which appears less expensive than bonds, Mr Bokobza suggests that the best way to express a belief on reflation is through “value” stocks, which look cheap relative to their fundamentals. Value as a style tends to underperform during periods of slow growth. With growth scarce, investors pay up for companies that can show strong and growing earnings, because growth is in short supply.
Therefore, counter-intuitively, value stocks tend to flourish as economies reflate. As the chart shows, both on an international and a US basis, the interplay between value and growth indices maps perfectly with shifts between “reflation-off” and “reflation-on” sentiment since the beginning of last year. After a revival, value has performed terribly again so far this year. Buy value stocks, and you are buying a cheap asset, which is never a bad idea: and if “reflation-on” sentiment comes back, there could soon be a catalyst to raise its price.
Should you do so? The slide in confidence over reflation so far this year, while economic data have remained robust, looks overdone. The safest way to be ready to profit from a return towards reflationary optimism is to buy value stocks.