In the early stages of the first quarter of 2017, the momentum behind inflation suggested we would see a wave of investor support for reflation – the investment stance built on hopes that global growth and inflation will advance further.
However, as March came to a close, the wave began to recede, prompting a slide in bond yields, the US dollar and other reflation trades.
But should investors reassess the reflation trade in light of these changing conditions?
Where the inflation has come from
It is worth casting our eyes back to the origination of the inflation pick-up. Over the past year, consumer price inflation has increased from 1 per cent to 2.7 per cent in the US, and from -0.2 per cent to 2 per cent in the Eurozone. These represent the highest rates of inflation since 2012 and 2013, respectively.
Some global factors had a hand in this increase, notably oil prices. While oil makes up just 5 per cent of the consumer price basket, high volatility in oil prices means it has had an outsized impact on inflation. Since January 2016, Brent crude oil prices have risen by 75 per cent, thanks to cutbacks in US shale oil supply and Opec’s agreement to curb production.
But the strength of inflation’s return was largely dependent upon local factors. For instance, domestic labour costs make up around 70 per cent of the consumer price basket for developed economies, and falling levels of joblessness in the US and Germany have contributed to higher wage growth and accelerating inflation in the services sector.
Currency movements also play a role. Here in the UK, it’s been well-documented that, thanks to the depreciation of sterling following the EU referendum result in June last year, prices of imported goods like food and energy have risen sharply. As a result, UK inflation has climbed above the Bank of England’s 2 per cent target.
Why the trade still has legs
This period of rapidly rising consumer prices is now likely to be over. But we don’t believe this means the reflation trade is done too. There are several factors which give us comfort that it still has legs.
Global growth continues to pick up speed: Most major regions – the US, Europe, and many of the emerging markets – are all growing at a faster pace, meaning that the acceleration is globally synchronised for the first time since 2010. This is likely to stimulate further job growth, lower unemployment, and higher wage packets for workers.
Earnings are accelerating: Like economic growth, corporate earnings are improving across regions. For S&P 500 companies, earnings-per-share (EPS) growth should continue the upward trend – we expect it to be over 10 per cent, the fastest in six years.
The benefits of Trumponomics may now be underappreciated: The failure of the President’s recent attempts at healthcare reform has reduced expectations for the passage of corporate tax changes. Therefore, any clear progress on tax reform in 2017 could be a tailwind for the reflation trade.
Where to invest
So how can investors harness the energy behind this wave?
With inflation rising, investors should allocate toward selected real assets, such as equities, real estate or inflation-linked bonds that could rise with inflation, rather than nominal assets such as cash or most bonds, whose purchasing power is likely to be eroded by inflation.
We see the best opportunities within three US assets: senior loans, energy and bank equities.
US senior loans: As inflation approaches the Fed’s target, we can expect a continuation of gradual rate increases. This should benefit fixed income products where the coupon can adjust upwards, like senior loans.
US energy equities: Selected US energy stocks offer good value, following the lowering of the oil price in March. We forecast a renewed rally in Brent crude oil from $50 to $65 over the next three months. Expected increases in free cash flow at the energy majors should be sufficient to cover capital expenditures and dividend payments in 2017. The dividend yield looks attractive and relatively safe. Moreover, these stocks should also be buoyed by a likely lightening of the regulatory burden under President Trump, while earnings should rebound sharply.
US bank equities: Inflation can be a friend for banks. Demand for loans increases; higher interest rates tend to lift bank net interest margins; and banks benefit from a lower rate of defaults on their loans. Again, regulatory reform offers a wind in the right direction. There’s mounting hope for gradual reform of the most opaque and complicated Dodd-Frank rules and a transition to less ideological regulations, if not an outright repeal of Dodd-Frank itself.
While we like energy and financials, investors shouldn’t fall into the trap of thinking all equities serve as a reliable inflation hedge. In contrast to our preferred stocks, bond-proxy sectors such as utilities and consumer staples often lack the ability to pass higher prices to consumers, and may struggle against the tide of rising inflation.
We are also underweight the US dollar relative to the euro. The greenback has been used as a proxy for the reflation trade, but we now see it as overvalued against the single currency.
We believe the reflation trade can power on through April and beyond, albeit with slightly choppier waters. For the most rewarding ride, investors should look across the Atlantic.