Alex Scott, Deputy Chief Investment Officer.
24 January 2017.
Investors have been sensing hints of inflation since the summer. With Trump’s election win in November, those hints became much less subtle. The US economy, already experiencing decent growth and some inflationary pressures, could be hit with a combined stimulus of tax cuts and infrastructure spending and, potentially, with tariffs on imports and curbs on migrant labour. The stimulus measures could boost growth, while the protectionist steps could be more disruptive. But importantly, each of these policies has scope to add fuel to the inflationary fire. It is little wonder that bonds sold off, the market pricing of inflation expectations rose and that related assets followed. A boost to growth and inflation suggests stronger revenue growth for companies; higher bond yields suggest wider lending margins for banks in particular.
Stockmarkets rallied strongly in the aftermath of Trump’s election win in November and carried much of that momentum through to the end of the year. They downplayed concerns about anti-globalisation policies and also shook off concerns that the failure of Italy’s constitutional reform referendum could reignite the Eurozone crisis: it didn’t. Banks and domestic US exposed stocks did especially well, and 10 year US Treasury yields touched 2.6% – their highest level since 2014 – before falling oil prices sparked an ultimately unwarranted deflation and recession scare. The US Dollar continued to rise, reaching its highest trade-weighted level since 2002, as it was boosted by the prospect of gradually rising interest rates in a world where the Euro, Yen and other currencies still carry negative interest rates.
US Government 10 Year Treasury Yield
But in the early days of 2017, the reflation trade has faded. The US Dollar has eased back, bond yields and inflation expectations have ticked lower, US equities have largely trod water, and banks and small-caps have given back some of their outperformance. What’s going on? There are two broad schools of thought.
This could be a pause for breath given markets travelled a long way very quickly after November’s election. They priced in continued resilient growth and inflation, plus a decent probability of tax cuts and a low likelihood of a dangerous trade war. They are now waiting for validation – from the economic data, from White House policy announcements – before resuming that momentum.
On the other hand, markets could be dangerously misreading the situation and have been stopped in their tracks by a belated realisation that the incoming President will not govern effectively enough to achieve the promised market-friendly tax cuts. They could now be appreciating that the American economy could be genuinely shaken if the White House policy on China shifts from inadvisable tweeting into an open trade war, inviting Chinese retaliation and further US escalation. One must hope that calm heads and wise advice prevail, but we cannot yet know whether they will.
It’s understandable that investors are concerned. We cut our Asian equity exposure in the face of this risk, and industry surveys suggest that most fund managers (in general) are cautious and holding high levels of cash. That might be the right stance, but repeated experience reminds us (from 2016 in particular) that investor caution ahead of known risks can be overdone and results in strong markets if investors’ worst fears aren’t realised…
“Clearly investors do not yet know which Donald Trump will govern over the coming months.”
Clearly investors do not yet know which Donald Trump will govern over the coming months: the protectionist micro-manager; the anti-China aggressor; the pro-business tax reformer; the ineffectual self-publicist; a President too beset by scandal to achieve much at all; or elements of all of the above. But one factor is a constant: inflation will be rising, mechanically and unstoppably, in the US over the next few months. It will be driven by the rebound in oil prices that’s already happened, rising rents, rising medical costs (perhaps rising rather faster if Obama’s Affordable Care Act is indeed scrapped) and rising wages all feeding into services prices.
White House policy may influence how investors respond to inflation. They may see it as a benign accompaniment to pro-growth policy or an invitation to the Federal Reserve for much higher interest rates to head off the risk of boom-and-bust. They may ignore it in a climate of growing risk aversion and buy low-yielding Treasury bonds regardless. We are not yet prepared to buy US Treasuries and give up on the reflation trade, but taking some profits on banks and financials, after a strong run since the election, may be worthwhile. We retain our significant allocation to longer term US inflation protection certificates: investors and markets are still pricing in inflation for the next 30 years well below typical levels and our position will benefit if long-term expectations continue to grind higher.
“While the reflation trade has been a widespread phenomenon, the UK (yet again) is a special case.”
While the reflation trade has been a widespread phenomenon, the UK (yet again) is a special case. Record highs for the FTSE 100 have been met with a fanfare, but investors could regard the FTSE’s performance as largely a ‘money illusion’ and a consequence of measuring the index against a devalued currency. As Sterling has fallen, so the future profits of the FTSE’s multinationals (that derive some 80% from overseas’ operations) have become more valuable. The FTSE’s gain reflects the Pound’s pain rather than being a vote of confidence in the UK economy. This is particularly clear when we look at the underperformance of domestically-oriented companies in the FTSE versus those which are most globally-oriented i.e. the underperformance of the mid-cap FTSE 250 versus the FTSE 100 index.
The UK will see inflation, but probably the wrong sort of inflation. Prices will rise because imports are becoming more expensive, not because of higher demand in the economy. It remains to be seen whether imported inflation – and the hit to living standards that this implies– will have a strong enough influence on public opinion around Brexit to change the government’s course, which currently appears set on a rather economically hard Brexit.
Will it divert us from the status quo that involves us leaving the single market, giving up most or all of the customs union arrangements, foregoing financial services passporting and potentially leading to both tariffs and non-tariff barriers (such as customs checks and regulatory divergence) with Europe? Unless the UK can continue to attract significant new capital inflows, or dramatically increase exports or cut imports, the current account deficit remains a headwind for the Pound – even at today’s low levels.
