The reflation trade has regained traction in recent weeks with global bond yields rising and renewed discussions in the US on tax and regulatory reform, promising a fiscal boost. Added to the mix has been rhetoric from central banks around the world on tighter monetary policy. Improving economic data and earnings growth globally have also been supportive.
Markets in September reflected this trend with cyclical equities leading the indices up, ending a four month run of underperformance. However, when we saw a similar trend in the second half of 2016, it was not sustained into 2017 and investors returned to the safety and stability of quality stocks. Is there more structural support for the reflation trade this time around?
Bond yields moved up in September as investors began to acknowledge the strength of the global recovery, reflected in rising Purchasing Managers Indexes (PMIs). Global GDP growth is expected to be around 3.5% in 2017 and 2018. Although inflation is still benign, the PMIs indicate that pipeline price pressures are picking up, while oil is close to its highs for the year. Earnings are also strengthening and have been revised up this year.
Europe and Japan led the rally in September. Europe is a key beneficiary of late-cycle inflation pressures and peak investment growth, while Japan benefits from rising yields. Sector leadership rotated in September, with the conventional reflation winners (energy, financials, industrials) topping the list as defensives struggled.
The Global Wave* from Bank of America Merrill Lynch (BAML), which quantifies global trends in economic activity in order to predict equity market performance and rotation within equities, improved for the 17th consecutive month in September. The confidence and earnings components of the Wave remain particularly strong. The Global Wave is positive on equity markets and cyclical rotation across regions, sectors and styles. It is now at levels seen during the 2004-7 expansion, implying an upward revision in earnings, the evidence for which is beginning to come through.
On balance therefore, the evidence suggests that the reflation trade has further to go. The synchronized upturn in global growth combined with a robust earnings outlook is positive for cyclical equities. Improving prospects for the US tax reform bill becoming law are also supportive. The recent BAML Global Fund Manager Survey highlighted investors positioning for higher yields, in particular via a significant rotation into banks. The survey also reported that 82% of respondents expect bond yields to rise.
Eventually though, rising inflation will be necessary to support higher rates. While so far, structural pressures have held inflation down, most of the disinflation has occurred when global growth has been below-trend. This is starting to change and, combined with stronger earnings growth and rising yields, should provide some more fuel to the reflation trade.
*The Global Wave quantifies trends in global economic activity and is an amalgamation of seven components: Global Industrial Confidence (Output); Global Consumer Confidence (Demand); Global Capacity Utilisation (Investment); Global Unemployment (Labour Market); Global Producer Prices (Prices); Global Credit Spreads (Bond Market); Global Earnings Revision Ratio (Equity Market)