The reflation story is broadening
IT HAS BEEN more than five months since President Trump’s surprise election victory infused new life into the eight-year long US equity bull market. Global markets have behaved as many, including us, anticipated: equities, riskier corporate bonds and industrial commodities rose, while government bonds fell, as business and consumer confidence indicators and corporate earnings improved after years of lackluster growth and inflation.
The Trump administration’s recent failure to push through a proposed health care bill to replace “Obamacare” through the US Congress amid Republican opposition can thus be seen as the first speed bump in this reflation rally. Investors are now questioning President Trump’s ability to make progress on the critical aspects of the reflation story -- implementation of corporate and personal tax cuts, business deregulation and increased infrastructure spending.
Given this, is it time for investors to hit the pause button? Or, is there more to the reflation story?
We believe a US tax deal will be reached, but that this will take time, especially since the Republicans will be keen to ensure that there are, optically at least, revenue-boosting elements to any stimulus package that make any tax cuts budget-neutral over the longer run. Therefore, while we are in the late stages of the US business cycle, we still believe the “reflation rally” can run for a while longer.
As it turns out, the reflation theme seems to be broadening beyond US shores, with economic and corporate earnings growth estimates generally being revised higher, especially in Europe and Asia. Interestingly, the fiscal policy debate in Germany, which until now had led the Euro area’s move towards greater austerity, also seems to be shifting back in favour of more easing. Any fiscal easing in Germany would be positive for Euro area growth. We are also seeing signs of a revival in Asian imports and exports, while Russia and Brazil are emerging from a couple of years of recession. China’s policy-induced stability has clearly helped in this regard.
This bodes well for the medium term (6-12 month) outlook for equity markets. Thus, global equities remain our preferred asset class. Earnings growth expectations are robust and the pivot from economic “muddle-through” to “reflation” suggests this is unlikely to change dramatically. However, a gradual shift away from extremely loose monetary policy settings and, in some regions, elevated valuations suggest future equity market gains will be driven by earnings growth as opposed to price-to-earnings multiple-expansion, which is normal feature at this stage of a cycle. Moreover, monetary policy remains supportive and momentum remains strong.
The Euro area is our preferred equity market.
Valuations are relatively low compared to the US, while 2017 earnings growth expectations have risen against the backdrop of an improving domestic economic outlook and reduced fears of a trade war. Signs of a pick-up in German consumption and rising exports across the Euro area thanks to prior EUR weakness imply the equity market could benefit from a virtuous circle of recovering domestic and external drivers.
We are also more constructive on the outlook for Asia ex-Japan equities. Economic data is improving and the US dollar’s stability should be a positive as it means domestic policy settings can remain loose and the region could benefit from a pickup in foreign portfolio inflows. Valuations are reasonable, earnings are expanding at a double-digit pace and the region remains under-owned by institutional investors. Within Asia, India and China (especially the “new economy” sectors) remain our preferred markets. South Korea may also benefit from reduced domestic political uncertainty, its significant investment in innovation and brand building and from the broader pickup in world trade growth.
Within bonds, there is a clear a preference for corporate bonds over government bonds and, particularly, for areas of the market that have less sensitivity to rising interest rates. This is because Developed Market government bond yields are likely to move gradually higher as the reflation story unfolds and the Fed gradually removes accommodation. Meanwhile, companies’ ability to service their debt is likely to improve under this environment.
Thus, our two preferred areas are US floating rate senior loans and Developed Market High Yield bonds. Both sub-asset classes have significant credit risk but, because of this, offer higher yields and lower sensitivity to rising yields. Indeed, senior loans offer floating interest rates, enabling them to benefit from rising yields.
We are a little more cautious on Asian bonds though. Issuers from China and Hong Kong have become increasingly dominant players in the Asian USD bond market. This exposes investors to higher concentration risks. Although China’s tightening capital controls and gradually rising interest rates have been successful in stemming outflows, any increase in concerns about China or reduced flows from Chinese investors could lead to sharp pullbacks in the market. Additionally, High Yield bond valuations in Asia look stretched. Therefore, we would prefer Investment Grade over High Yield bonds and favour higher-quality exposure within the High Yield debt market in Asia.
Of course, there are always risks of short-term weakness in equities and other riskier assets, especially at this time of the year, given seasonal tendencies and the upcoming elections in France. While we do not expect Eurosceptic parties assuming power and undermining the global, or even regional, economic outlook, there are clearly risks of at least temporary market volatility as the polls fluctuate.
Also, some market indicators, such as implied volatility across different asset classes, do hint at investor complacency. However, fund manager surveys show there is still significant cash sitting on the sidelines which has yet to be deployed into markets. This is usually an indication of further equity market upside. More anecdotally, we see a similar phenomenon when it comes to client behavior, with most still focused on income-generating assets rather than pure growth-oriented assets. This implies that any pullback on pro-growth assets is likely to be relatively limited and an opportunity to add exposure.
Steve Brice is Chief Investment Strategist at Standard Chartered Private Bank.