Is reflation nearing the end of its run?

Barnard, Jenna_700x450

There is a strong consensus in markets these days. Post-Trump election, terms such as “regime change” and “the Trump reflation trade” have dominated financial press headlines, as investors put their money to work based on the view that growth and inflation are going to rise. This has favoured equities over bonds.

However, the catalyst for the rise in bond yields actually pre‑dates the US elections. There have been signs of growth picking up in the major economies since mid-2016. Indeed, economic surprise indices showed a cyclical uplift prior to Trump’s victory, with purchasing managers’ indices indicating a concerted uptick in global activity.

This trend occurred in response to a number of factors, including a loosening of monetary policy in China about a year earlier, sparking a rally in commodities. Thus the rotation seen in equities from defensives to cyclicals and banks, the consensus move on being long the US dollar, and rising bond yields were already in progress. Trump’s election simply amplified it. A Trump bump, if you like.

What next?

Headline inflation is on the rise around the globe on the back of rising commodity prices, while core inflation (which excludes volatile items such as food and energy) remains more muted.

In the US, the increase in activity and expectations of expansionary policies have helped the trend, while in the UK the commodity uptick has been exacerbated by a weakening sterling following the Brexit vote. Headline inflation trends are similarly on the way up in Europe and Japan.

Given the inflation expectations, consensus among market participants now appears to be for a rise in 10‑year US treasury bond yields to 3 per cent, which would represent a further significant sell-off in bonds.

Additional data shows short positions in US government bond futures have reached extreme levels compared with history.

A cyclical uptick, not a structural trend

We believe the current uptick to be cyclical in nature, which should not be confused with the long‑term structural issues we have talked about for so long (productivity, demographics and digitalisation to name but a few) that ultimately lead to lower growth and subdued inflation.

Furthermore, there is evidence money supply growth has been declining in China and the US in recent months. Given monetary changes usually lead activity swings by between six and 12 months, this indicates a mild slowdown around spring time.

With this in mind, we believe consensus positioning has gone too far, which is perhaps a sign the reflation trade may soon have run its course.

All in all, this is not an unusual picture and does not represent a regime change. It simply reflects the normal ebb and flow of economic cycles.

Although we believe the current run of inflation will likely tail off by the second half of the year, we manage portfolios pragmatically. Going forward, given low default rates in Europe, while those in the US have peaked, should the consensus prove correct, any sell‑off in bonds should be viewed as an opportunity to find quality investment grade US corporate bonds.

The current yield levels present more of an opportunity than a threat. The biggest threat to portfolios is a systemic risk in Europe as a result of politics.

We continue to favour sensible income from large, non-cyclical businesses, which are most likely to continue paying their coupons in the years to come. Coupons should look after investors reasonably well this year.

Jenna Barnard is co-head of strategic fixed income at Henderson Global Investors