Download The Reflation Trade Is Full of Hot Air

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.
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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.
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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.
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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.
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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.
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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.
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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.
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