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The Reflation Trade Is Full of Hot Air INVESTMENT INSIGHTS February 2017 IN BRIEF •The reflation trade underpinning the recent market rally suggests strong confidence in the ability of the Trump administration to deliver expansionary fiscal policies and improved economic growth. •Nascent signs are emerging of rising inflation, evident in headline consumer price data and sentiment indicators, but we see little evidence of accelerating core inflation that would suggest potential overheating of the global economy. •Working against any possible mounting global inflationary pressures are a number of secular disinflationary factors, notably debt, demographics, technology and globalization. •While economic activity has rebounded since the lows of mid-2016, we have yet to escape the mediocre global growth envelope we have been operating in since the end of the financial crisis in 2008/2009. While global economic activity has rebounded since the lows of mid-2016, we have not yet broken free of the mediocre global growth envelope we have been operating in since the end of the financial crisis in 2008/2009. •It is not clear that the Trump administration will be able to deliver reflationary policies and an increase in economic momentum commensurate with current market pricing. The market has cheered — loudly — and given the new Trump administration a resounding thumbs up. In this new world, corporate and personal taxes will drop dramatically in short order, infrastructure spending will assert itself and regulations will be a major inconvenience of the past. What’s more, new tariffs and trade policies will be benign and not likely to provoke a trade war with Mexico or China even as they focus on “America First”. Moreover, members of Congress will march in lockstep with the White House when they’re asked to rubber stamp the expected fiscal packages. Sound like the world we live in? We’re not so sure. Through the president’s inauguration on January 20, investors in the market had bought into Trump’s promise to “Make America Great Again” and the reflationary themes that anticipate stronger activity, more favorable trade deals for the United States, and higher inflation and interest rates. The argument is that these fiscal and regulatory policies will drive investment, productivity and hiring, put an end to fears of deflation and create a virtuous cycle of economic prosperity. The election outcome triggered a change in stock market leadership: defensive higher-yielding sectors, like utilities and real estate trusts (REITS), have sold off in favor of cyclical stocks — financials in particular — which benefited from the expectation that the new administration will loosen regulations and reduce taxes. In keeping with this “risk-on” trade, investors reduced their holdings of government bonds and added to equity and credit allocations. It is difficult to ignore how inconsistent it is to have such high conviction on the Trump-inspired reflation trade while at the same time acknowledging the historically high level of uncertainty over both the global economy and the path of Trumponomics. page 1 of 7 INVESTMENT INSIGHTS February 2017 Is the reflation trade a sustainable theme? Is there evidence of fundamental macroeconomic strength to suggest the global economy is at an inflection point that will propel stronger growth for a considerable period of time? These are the key questions we examine in this investment briefing. In doing so, we look at both cyclical and secular factors in the current global context. Current economic cycle: What do we know? In our minds, there are two threads to the reflation trade: real growth and inflation. A rise in both would signal improved global demand and possibly excess demand, but would also likely be consistent with, among other things, accelerating corporate revenue growth and a sustained rise in bond yields — both of which have been quite low relative to past economic cycles. To be sure, we were seeing some indications of accelerated economic activity and inflation (domestically and globally) before Trump won the election, and there have been further signs of improvement since. On all fronts, however, the evidence is not only embryonic, but also indistinguishable from prior post-crisis moments of improved conditions that ultimately proved fleeting. Indeed, most of these positive developments so far appear to be merely a rebound from a particularly weak global period during early-2016. Exhibit 1: Global Manufacturing Purchasing Managers’ Index (PMI) 54 J.P. Morgan Global Manufacturing PMI 53 Index level We are seeing signs of less disinflation, but no real evidence of an increase in core inflation. While recent sentiment indicators in Japan, Europe, China and the United States have risen, we need to keep in mind that these are not measures of actual economic activity, but rather measures of ‘perceptions’ of activity. For example, the Global Purchasing Managers’ Index (PMI) is a sentiment indicator that has risen recently (Exhibit 1). The increase could reflect cyclical ebbs and flows, rather than a sustainable jump-start to the global economy. Without a meaningful pickup in capital spending, PMIs may very well retrace without generating a sustained pickup in economic growth. . 52 51 50 49 2014 Expansion Contraction 2015 2016 2017 Source: Bloomberg, Markit, J.P. Morgan as of 31 January 2017. Index is seasonally adjusted. In this diffusion index, values above 50 indicate expansion and values below 50 indicate contraction. We are also seeing some signs of nascent price pressures, evident in headline inflation data, but little evidence of firmer core inflation (Exhibit 2). In the absence of a meaningful and sustainable rise in core inflation, we remain skeptical. page 2 of 7 INVESTMENT INSIGHTS February 2017 Exhibit 2: Headline and core inflation (YoY%) Average of select countries/regions 2.5 Headline inflation YoY% (average) Core inflation YoY% (average) YoY% 2.0 1.5 1.0 0.5 2014 2015 2016 Source: Bloomberg as of 31 December 2016 (quarterly frequency). Countries/regions include United States, United Kingdom, Eurozone, Japan, China, Canada and Australia. The average is calculated based on a simple average (not GDP-weighted). Absent an improvement in capital spending, it is difficult to see fundamental economic strength in the global or US economies. The primary driver of the rise in year-over-year headline inflation over the past several months is the base effects from the decline in the price of oil in late-2015 and early-2016. This has led to an increase in headline inflation, but so far we haven’t seen much leakage into core inflation. It’s unclear if the rise in headline inflation is a sustained increase or a one-off rise. When the oil price moves above US$50 a barrel, US shale production increases significantly, so the potential inflation rise is somewhat capped by this supply response. Moreover, the desirable kind of inflation is demand-driven, rather than the type that stems from higher oil prices, which will squeeze spending elsewhere and ultimately be disinflationary as a result. Think about it in the extreme. If the price of oil rises to $500 a barrel, inflation will spike and then roll over after people are forced to stop buying nonessential goods and services. Muted investment spending The current business cycle has been characterized by historically low capital spending. For example, in the United States, the latest data for real non-residential fixed investment — one of the building blocks of a durable economic expansion — show no growth from the prior year. Excess capacity in manufacturing is one reason for this outcome. Companies have little incentive to invest in capital when there is excess capacity, which is driving down prices and leading to margin pressure. An increase in investment spending would be a clear sign of a sustained improvement in the growth prospects of the global economy. However, currently, there is little evidence of this (Exhibit 3). Absent an improvement in capital spending, it is difficult to see fundamental economic strength in the global or US economies. Additionally, the hope that US regulatory and tax reform (especially with regard to repatriated foreign profits) might ignite capital spending seems unjustified given that corporations have been allocating cash in less constructive ways by 1) giving their excess cash back to shareholders in the form of dividends, 2) buying back equity shares and 3) ratcheting up mergers and acquisition activity. page 3 of 7 INVESTMENT INSIGHTS Exhibit 3: Industrial production in advanced economies 115 Index level (2010 = 100) February 2017 110 105 100 95 90 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Bloomberg, CPB Netherlands Bureau for Economic Policy Analysis as of 30 November 2016 (volumes). Shaded areas = US recessions. There are indications the global economy is becoming less deflationary and has bounced back from a particularly weak period, but signs of more than moderate growth and inflation are yet to be seen. Furthermore, an expansionary fiscal package this far into a business cycle is rare and could have counterproductive consequences. If the US economy is operating close to full capacity, the “reflation” trade is far more likely to be tilted towards inflation without much of an increase in real growth. The US Federal Reserve would probably raise interest rates more aggressively, threatening the longevity of the current business cycle, if this turns out to be the case. Moreover, higher short-term interest rates and a stronger US dollar would likely undermine this reflation narrative and could create global market turmoil, as it has in the past. In sum, so far there is little evidence of a sustained rise in global growth and inflation. There are indications the global economy is becoming less deflationary and has bounced back from a particularly weak period, but signs of more than moderate growth and inflation are yet to be seen. Secular factors Any credible cyclical growth projection needs to take into account secular disinflationary factors that frame the dynamics in the global economy far more profoundly than policymakers and politicians would have us believe. These include: debt, demographics, technology and globalization. Debt – The developed countries hold a toxic combination of elevated public and private sector debt, greater than the high water marks of 2008 — and debt levels continue to rise (Exhibit 4). The burden of high debt levels tends to be disinflationary, (unless a central bank and finance ministry team up to hyperinflate their economy, as with Germany in the 1920s or Zimbabwe in the 2000s). High debt levels often preclude interest rates returning to “normal” because the economies would have difficulty meeting the debt service burdens that accompany higher rates. Demographics – It is well known that aging populations and low fertility rates characterize most of the developed world. This path results in fewer workers in the labor force, working shorter work weeks at lower levels of productivity, which leads to lower economic growth. Belowreplacement-level fertility rates is a feature not just of the developed world, but also increasingly also of the developing world. Only in Africa and a handful of other less-developed countries are birth rates above replacement levels. page 4 of 7 INVESTMENT INSIGHTS Exhibit 4: World debt-to-GDP (non-financial) 250 February 2017 240 Debt-to-GDP % 230 220 210 200 190 180 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: BIS and Ned Davis Research as of 30 June 2016. Ned Davis Research data from December 1998 to September 2001 — global composite based on largest countries by GDP. BIS data from December 2001 to June 2016. Shaded areas = US recessions. These demographic trends are depicted in Exhibits 5 and 6, which highlight the precipitous decline in population growth that began a few decades ago, along with the accompanying rise in the old-age dependency ratio (the proportion of retirees relative to the working-age population). In the United States, the rapid pace at which baby boomers are retiring is acting as a natural brake on the aggregate wage pie, as new hires are typically younger, less experienced (and more likely to be part-time), and consequently, paid less. These demographic trends are having very significant and increasing disinflationary effects on the global economy. It is difficult to overstate their impact. Exhibit 5: G7 population growth Change in world population YoY% (1950–2065) 3.0 Less developed regions More developed regions 2.5 2.0 1.5 YoY% These demographic trends are having very significant and increasing disinflationary effects on the global economy. 1.0 0.5 0.0 -0.5 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 Source: UN Population Division — World Population Prospects (2015 revision). Total population, as of 1 July 2015. Mean estimates shown (2015–2065). Vertical line indicates 2015. page 5 of 7 INVESTMENT INSIGHTS Exhibit 6: Old-age dependency ratio for developed regions, 2000–2065 50 February 2017 Old-age dependency ratio 45 47.6 40 35 30 26.7 25 20 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 Source: UN Population Division — World Population Prospects (2015 revision). Ratio of population 65+ per 100 population 15-64. Mean estimates shown (2015–2065). Vertical line indicates 2015. Contrary to popular opinion, many more jobs are being lost to automation than to global outsourcing, and this trend will only continue. Technology/Automation – One of the few things we can say for certain is that technology and artificial intelligence (AI) are accelerating in their power and application. And, while technology has enhanced our lives immeasurably, it also has an unpleasant underbelly. It is highly disruptive and deeply disinflationary. Contrary to popular opinion, many more jobs are being lost to automation than to global outsourcing, and this trend will only continue. E-commerce is great for consumers, as it affords comparison shopping and lower prices, but it has also dislocated many industries and led to widespread job losses. Digital platforms operate with very little capital and labor and, yet, can have large-scale impacts (e.g., Uber and Airbnb). These platforms are enhancing market efficiencies and promoting the “sharing economy” and “dematerialization.” Needless to say, these are all disinflationary trends. As the disinflationary impact of technology and AI becomes more apparent, the creative minds in Silicon Valley would be wise to work with policymakers to consider the full societal effects of technological innovation. Globalization and trade – Globalization has undoubtedly improved the lives of significant swaths of the population in the developing world, in Asia in particular, as growth and labor income has risen with the increase in trade and outsourcing of manufacturing. Globalization has had an adverse effect on some workers in the developed world, however, and the economic and social dislocation this has caused is now being more fully recognized. There is a growing appreciation of the disinflationary impact of globalization as well. The prices of goods and services are being set in a much more competitive global marketplace. page 6 of 7 INVESTMENT INSIGHTS February 2017 It’s not clear the Trump administration will be able to sustainably deliver reflationary policies and an increase in economic momentum. It is also difficult to ignore the number of weighty secular disinflationary factors at play in the global economy, which form the backdrop for cyclical economic activity. Conclusion While the market appears to be pricing in all the potentially positive “reflationary” elements of Trumponomics — tax and regulatory reform in particular — the administration’s policies on trade and immigration barriers— as well as the more confrontational geopolitical agenda appear to have been discounted considerably. In our view, it’s not clear the Trump administration will be able to sustainably deliver reflationary policies and an increase in economic momentum. It is also difficult to ignore the number of weighty secular disinflationary factors at play in the global economy, which form the backdrop for cyclical economic activity. While we are observing signs of less disinflation, there is no real evidence of an increase in core inflation. We are also not seeing indications of any significant rise in investment spending, which would point to a macroeconomic environment supportive of a sustained improvement in global economic growth. This missing piece is an important precursor to the higher productivity required to boost the global economy’s potential, raise living standards and (possibly) lower risk premia. While global economic activity has rebounded since the lows of mid-2016, we have not yet broken free of the mediocre global growth envelope we have been operating in since the end of the financial crisis in 2009. We are not ready to add our voices to the hopeful market chorus. We continue to believe we’ll be in a lower return environment for some time to come and that investors would do well to stay the course and take a long-term view of their investment approach, remaining particularly cognizant of the importance of risk management during uncertain times such as these. Authors Erik Weisman, Ph.D Chief Economist & Fixed Income Portfolio Manager Robert Spector, CFA Fixed Income Portfolio Manager The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries. Issued in the United States by MFS Institutional Advisors, Inc. (“MFSI”) and MFS Investment Management. 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