Equity markets took a breather, possibly waiting for further confirmation that the reflation trade marks the shape of things to come. Bond markets have been more sceptical anyway, with 10-year yields having moved broadly sideways since December and having slipped more recently. In this uncertain environment credit has done well, with underlying yields low or falling and yield spreads generally narrowing.
WAITING FOR CONFIRMATION ON REFLATION
Reflation can be seen clearly in a number of indicators. Producer prices in China have surged from -5.9% YoY in December 2015 to +6.9% this January, in part reflecting the traditional correlation between commodity prices and producer prices. But it now looks like Chinese producer prices have now moved ahead of the levels that commodity prices would project. Base effects (low inflation a year ago) may play a role and inflation is strongest in upstream, commodity-related industries, but we do see this as a sign of reflation. Elsewhere, South Korean producer and export prices, which are less sensitive to commodity prices, have also swung from deflation to inflation, while US and eurozone producer prices have started to rise.
Higher inflation would in theory be positive for equities, enabling companies to raise selling prices, margins and thus profits. Higher bond yields could have a dampening impact on equities through a lower valuation, but based on historical relationships, current yields are too low, reflecting too much uncertainty about geopolitics, growth and inflation, in our view.
REFLATION: MUCH DISCOUNTED IN THE MARKETS
Markets have largely discounted the reflation trade in the past few months, allowing equities to rally in all major regions and taking credit spreads to the lowest levels since the financial crisis. It should be noted that investment-grade corporate bond spreads in Europe have, however, widened over the discussion about the ECB tapering its asset purchases.
We see headwinds for the reflation trade. One is obviously that it is widely discounted. The second is that inflation has not shown up everywhere. Core producer prices in the US (stripping out food and energy prices) have remained muted and core consumer prices have moved sideways for more than a year. Eurozone core consumer price inflation has been below 1% for 10 straight months and the ECB has signalled that it is willing to look through the temporary impact on headline inflation of higher energy prices. Wage inflation is only showing up in the US, but it is much lower that the tight labour market would suggest. Finally, most of the inflation that we currently see is driven by dearer commodities. This is not the type of inflation that would be beneficial. It actually increases costs for companies and households.
LATE -CYCLE REFLATION: GOOD FOR EQUITIES?
Adjusted for inflation, wages are hardly growing in the US and Japan. Consumer confidence slipped in the US and the eurozone in February, albeit from high levels. Still, indications of the negative impact of rising energy prices on consumer spending are something to watch for. On the relationship between equities and rates/yields, things may be different this time in the US. Normally, equities rise when the Federal Reserve raises interest rates in the early stages of the economic cycle since higher profits more than offset a compression in price-earnings ratios. Currently the US cycle is well advanced, which should leave less room for profit expansion.
Political uncertainty is still high. In the US President Trump will this week unfold his fiscal plans, but it remains to be seen how much detail and clarity will be given. And will Congress play along if there is a big budget deficit in the plans? Will there be any indications of protectionist measures? It now seems that the infrastructure spending plans have been moved to 2018.
In France independent presidential candidate Emmanuel Macron got a further boost from political support, raising his chances of getting through the first round of the elections. French government bond spreads versus Germany narrowed, although spreads in France, Italy and Spain are still somewhat above the levels of the past few months.
FED SIGNALLING A MARCH RATE RISE?
Back in December, the median of forecasts for the fed funds rate by individual policymakers increased for the first time in years, rising by 25bp to 1.375% at the end of 2017. With the fed funds rate currently at 0.50% to 0.75%, that would imply three rate rises this year. The Fed does not specify a path for these increases, but given the now stable growth and gradually falling unemployment, we believe it would not make sense for the Fed to pause on rate rises in the first half of the year and then implement accelerated increases in the second half.
Of course, these forecasts are not set in stone. At the end of 2015 the Fed appeared to be looking for four rate rises and in the end we got only one. We should note that the dispersion of forecasts among policymakers is high. The two most dovish members see only one rate rise and the most hawkish member sees the fed funds rate at 2.125% by the end of the year. Fed policy remains data-dependent, but recently the central bank has sounded more hawkish. Fed chair Yellen told Congress that waiting too long to remove accommodative monetary policy would be unwise since it might mean that interest rates will have to be raised rapidly eventually, which would risk disrupting financial markets and pushing the economy into recession. She strongly suggested that rate rises will be discussed at the upcoming monetary policy meetings. That does not specifically point to the policy meeting in March, but it is certainly an option.
FED EXPECTED TO PRIORITISE RATE RISES
In short, the Fed sees enough progress in inflation and unemployment to justify further rate rises. It wants to raise rates to have its traditional monetary tool of fed funds adjustments back and regain traditional policy flexibility. The pricing of fed funds futures suggest a 40% probability of a rate rise in March. This percentage might be low for the Fed’s comfort, but in the eyes of the markets, the relevance of the March meeting has surely increased.
Interestingly, the more hawkish comments appear to have hardly impressed equity markets. They paused after Yellen’s testimony to Congress and after the publication of the latest policy meeting minutes, but nothing more than that. Perhaps markets see this news as confirmation of the reflation trade and believe that the traditionally positive correlation between equities and the fed funds rate early in the tightening cycle will still hold. The unresponsiveness of government bond yields also helped steady equities, of course. Why did yields not react? Are investors more worried that the economy will not be able to cope with higher rates? This could be: banks have recently been more cautious on making business and consumer loans. Accordingly, loan growth has eased.
ASSET ALLOCATION: CAUTIOUS ON EQUITIES
We are underweight equities since we think they are slightly expensive and we are reluctant to follow the market’s optimism on the outlook for earnings. As a hedge for stronger growth and inflation, i.e., for upside risks for risky assets, we are overweight in European real estate versus broad EMU government bonds. We are underweight in US high-yield corporate bonds, emerging market debt in US dollars and commodities.
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