What really is the reflation trade ?
We believe that what the markets call the “reflation Trade” can be divided into two different aspects.The first aspect, which started before the election of Mr Trump, is the proper reflationary trade meaning higher nominal growth priced in financial markets. We believe that this element is first and mostly due to the very accommodative economic environment and monetary conditions enjoyed in the 2nd half of last year : thanks to higher oil prices, tighter credit spreads, very low real interest rates (FED on hold for most part of the year), depreciating USD, and supportive economic policies in China, macro momentum has improved in the US and in most part of the world. With higher oil price, tight labour markets (US), and better macro momentum (led by an improving manufacturing sector after a very depressed 2016H1), markets have started to cut the implicit probability of deflation/recession priced into financial markets and to revise higher inflation/growth expectations. This had led to a bullish momentum for equities, with an outperformance of value stocks and financials as well as higher US rates and the USD.
The second aspect of the “reflation trade” is directly linked to the US presidential election and to Mr Trump’s announced fiscal policy. Indeed, according to the electoral program, investors have started to price in the impact of the infrastructure spending plan, of the corporate tax reform and of the border-adjustment taxes on US inflation. This second leg of the “reflation trade” has seen a further dollar appreciation, a continuation of the value stocks and financials outperformance, and has also seen a further increase in global bond yields. The “Trump reflation trade” has been also sustained by a positive confidence shock with a positive impact on risky assets, at least until the end of the last year.
Due to stretched valuations, any disappointment on Mr Trump’s capacity to deliver at least part of the fiscal package will be clearly sanctioned by market participants, especially on expensive US equities. That said, we believe that a more consensual approach regarding global trade and less confrontational views regarding foreign currency management are good news as no-one, not even the US, would benefit from high FX volatility, currency war, protectionist measures and flying USD. Additionally, we are of the opinion that the first part of the reflation trade is still very valid : macroeconomic environment seems solid, oil prices are expected to stay relatively unchanged at a level that will not scare financial markets, inflation figures have positively surprised, especially in the Eurozone where deflation fears were still alive, FED has some room for manoeuvre to continue to gently tighten US rates (as growth momentum is solid and terminal Fed fund rates are expected to remain low in a highly leveraged system and late cycle environment) and the US are well aware that a spike in the USD Trade Weighted Index would be detrimental to the US and the rest of the world economy.
This is the reason why we continue to be positioned for a continuation of the reflation story, especially on equities (long and value) in combination with some search for yield approach (EMD) and cautious view on core rates (playing some range trading).
In the fixed income universe, we are short duration in benchmarked funds and have very limited exposure to core sovereign bonds (especially German and French bonds). In the US, the recent bond market positive performance should be seen as temporary. Tight labour market and rising wages should ensure a pick up in core inflation, driving the 10 US Treasury to our target (2.6-2.8%). In addition to the short duration, we keep an overweight to corporate bonds and namely to high yield corporate bonds as spreads should continue to tighten in a supportive growth environment.
Multi-Asset Portfolio Manager
Gross performances of our strategies (April 28th, 2017)
Amundi, data as at end of April 2017. Gross performance of “Balanced Institutional Absolute Return Low volatility “, Multimanager Multi-Asset Fund of Funds (Bonds)“ GIPS composites in euro. Their respective benchmarks are: Eonia capitalized and a composite benchmark: 50% JPM EMU Government Bond Index, 30% JPM Government Bond, 20% Exane ECI – Europe Convertible. Past performance is not a reliable indicator of future results or a guarantee of future returns.