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After bolstering markets for most of the second half of last year, the reflation theme had actually dwindled during the first part of this year. Growth was still good and broadened out further, while politics turned for the better (or less worse). However, the resulting tightening in labour markets and rebounding corporate profits did not translate into stronger price pressures or rising wages. And without the “nominal” part of the economy coming back to life, the reflation narrative continued to look a bit crippled in recent months.
As a result, the likelihood of more hawkish behaviour by central bankers became lower and markets refocussed on a solid, but sideways path for the “real” economy. This environment keeps earnings growing, holds defaults low and gradually tightens labour markets further.
But since it is uncertain to lead to clear acceleration in the growth of nominal cash flows, like household and corporate income, it struggles to lift assets that depend most directly on expectations of future growth in income streams. Therefore, the more cyclical and growth depended parts of equity markets lost some of their stamina in 2017 and fixed income spread products, like corporate credit, High Yield or Emerging Market Debt, steamed ahead. For the latter part of markets, a steady world where cash flows are predictable, defaults remain low and balance sheets are controlled well rather than geared up further is actually optimal. Moreover, a low nominal growth world also keeps the search for “income” (yield and dividend) in the focus of savers and thereby keeps demand for spread products high.
But then something seemed to change last week. The winds of reflation started blowing through markets again as bond yields jumped up again, inflation expectations rose and equity markets reached new record highs with cyclical stocks firmly outpacing credit and defensive income and low-vol equities. Whether this will persist and bring a real reflation redux is too early to tell, but it cannot be excluded.
Globally economic growth remains not only at the upper-end of its trading range, but it is more broadly supported than it has been in a decade. With the emerging world joining the developed world in a recovery an important pillar for growth resilience has been created over the last year. Furthermore, with both the developed world and the emerging world it seems that more diverse sources of growth have become visible this year. In the developed world, it is crucially important that business investment has joined consumption to support the demand backdrop. Part of the recent market behaviour might have also stemmed from the fact that capex indicators and industrial orders have been accelerating again recently, hinting at a solid 8% annualized growth pace in global capex over the last three months. Moreover, within the emerging market spectrum it might be visible that Chinese growth is flattening out somewhat, but it is also increasingly clear that more and more smaller emerging market economies are joining the recovery on the back of easier financial conditions and improving credit growth.
Probably even more important over the week was the fact that finally some inflation data surprised on the upside, with especially the larger than expected rise in US core inflation probably weighing on investor thinking. Partially because it fed into a theme of more hawkish signals from central banks, with the Bank of Canada hiking rates and the Bank of England hinting at hikes to come. And obviously markets also realised that the modest updrifts now visible in underlying inflation in both the Eurozone and the US create a more credible backdrop for the ECB and the Fed to pursue their desired course of unwinding their QE policies gradually further.
Another important aspect on especially the US inflation number was that it might have reduced a little of uncertainty over the distance to travel before bottlenecks in the system start to create price and wage pressure. It has become very clear to investors and central bank staffers that the historical relationship between labour market tightness and the evolution in prices or wages has changed. As a result, it has become hard to understand or forecast under what economic conditions inflation might actually start to accelerate. Therefore, it is even harder than normal to anticipate central bank behaviour. This small step in actual inflation prints will not unwind this uncertainty altogether, but it might have helped to reduce the inflation uncertainty premium in markets just a bit.
The changing dynamics observed in markets and accompanying observations about the underlying economy do not yet justify a sharply increased conviction on a reflux of the reflation theme. It does tell us that we should stay on guard for the comeback of investor focus on the topic. Many things might be different than in the past in our economic system, but change will continue for ever. That also means that the low growth, easy central banks and search for income themes will at some point change. With that awareness, the readiness to gradually adapt when new information comes by becomes clear. For now, we hold on to an allocation stance that is cautious on government bonds and seeks small risk exposures in income generating asset classes like real estate and spread products. Once more evidence of a renewed drive up the reflation path is found over the next couple weeks than our risk tilt might well be redirected back toward equities. Stay tuned!