The Silver Bullet | Is the Reflation Trade Over?

The global reflation trend that started last year has hit a wall. Inflation expectations are falling back. Bond yields and stock prices have also stopped rising.

Is the reflation trade really over? The short answer is no.

The recent pullback is due to investors’ loss of conviction in growth momentum and policy direction. Are these worries justified? While recent macro data points to a continued recovery in both Europe and the US, we believe growth acceleration may have peaked in the US. There are risks, too: the recent FBI investigation poses a challenge to the Trump administration’s fiscal plans. Concerns about policy tightening in China have resurfaced.

That said, we believe markets may have swung from over-excitement to excess pessimism: the reflation trade is not dead, it is moving to Europe. We see more upside in growth surprises and inflation in the Euro area. President Macron’s victory in France and Merkel’s likely re-election will open a window of opportunity for European leaders to work towards more integration, as we recently argued on the FT. This means more fiscal coordination and public spending in the short term and progress on long-term projects including the Banking and Capital Markets Union, a stronger European Stability Mechanism and potentially a fiscal transfer framework (The Silver Bullet | Europe’s Opportunity). In addition, the ECB is likely to begin its policy normalisation this year as the economy continues to strengthen. Investors, many of whom were still expecting a high probability of a Euro breakup until last month, do not price these policy developments in. We estimate the most upside in Euro FX and rates, but also believe credit and equities will perform well over the coming months.

Growth: US and China stabilising, Europe Still Has Momentum

Growth in the US has entered a stabilisation phase, in our view. Economic activity remains strong, but growth momentum may have peaked – starting from the high bar set last year by high expectations on new policies. China, on the other hand, is purposely trying to engineer a controlled slowdown, after almost a decade of fast growth fulled by credit expansion. For the first time in years, Europe seems to offer a better growth outlook vs expectations, compared to other major economies.

US soft vs hard data: the gap could close in the middle. The Trump-led US recovery has so far been characterised by a strong divergence in “soft” macro data (surveys, consumer and industrial confidence, etc.) vs “hard” production and jobs data. We think the administration will implement some of the planned policies – but may fall short of delivering a full-fledged tax reform. The weak Q1 GDP print of 0.7% QoQ annualised is likely skewed by seasonality and weather factors, and should rebound in Q2. The New York Fed’s Nowcast model is forecasting Q2 real growth at 2.3%, 0.5pp higher than at the start of May. The labour market has also tightened further, with unemployment rate now below pre-crisis lows and the OECD’s estimate of the natural rate of unemployment (NAIRU). Yet these improvements are already taken into account by the Fed, which could soon start pushing on the brakes.

Macro data will continue to surprise to the upside in the Euro area. The European economy has turned out stronger and more balanced than investors expected, despite political risks in the first half of the year. While France and Italy have lagged, other countries including Spain, Ireland and Portugal are growing at above 2% YoY. Both bank and corporate profitability have improved, with more firms showing earnings beats than misses: the average earnings surprise for STOXX 600 on a market-cap basis was +10% in Q1 2017, the highest since 2009. Banks – the main credit intermediary in the Euro area – are also starting to make new loans, after almost eight years of deleveraging. In addition, we expect a Macron-Merkel Franco-German alliance to form, which should bring in more pro-growth measures and fiscal spending.

In comparison to China and the US, Europe has relied less on the credit lever to shore up growth post-crisis, which means there is upside room from now. As shown left, total credit to the non-financial sector has grown at an annualised rate of 18.9% in China, 4.6% in the US and 0.9% in the Euro area in 2008-2016. This has correspondingly led to faster real GDP growth in China and the US during the same period.

Monetary Policy: Don’t Underestimate Hawkish Surprises

Central bankers globally seem to have adopted a more moderate tone this year, after signalling a major shift in strategy from QE Infinity to focusing on monetary transmission last summer. Will flatlining growth rates push them back into easing mode? We don’t think so. In the US, policy normalisation is necessary to avoid overheating in labour market, and in the Euro area, to curb growing imbalances amongst member countries coupled with fiscal spending (The Silver Bullet | Europe’s Long Way out of QE Infinity).

Wage growth is likely to pick up in the US, putting the Fed at risk of falling further behind the curve. The Fed’s March dot plots have guided for two more rate hikes in 2017 and three each in 2018 and 2019, with the long run terminal rate at 3%. Several FOMC members have already signalled that they will look through the weak Q1 data, with Yellen calling quarterly GDP a “noisy” indicator. However, this is still a much shallower hiking path and lower terminal rate compared to previous cycles. One reason for the gradual path this time around is lack of inflation, with core CPI rising only 1.9% YoY in April. However, with the labour market already at full employment and unfilled job openings rising further, the risk of wage acceleration and inflation overheating is high. This is despite the lack of a recovery in the labour participation rate, which is more likely caused by structural factors including demographic changes, as the St Louis Fed argued. In the worst case the Fed may be forced to make snap upward adjustments to its policy forecasts.

Markets may be complacent about Fed risks. In our view, currently investors are probably too focused on likely disappointment from President Trump’s tax reforms and fiscal policies, while overlooking the risk of a more hawkish Fed following an overheating labour market.  Despite the Fed’s already shallow policy rate path projection, markets are pricing in even slower rate hikes. In addition, US financial conditions have continued to ease over the past six months, shrugging off two rate hikes and the Fed’s indications of impending balance sheet reduction. This means markets could be caught unprepared if the Fed accelerates its policy normalisation, with the most vulnerable assets being US HY and EM assets.

In Europe, we think the ECB will begin policy normalisation this year. Recently, ECB President Draghi noted that the “crisis is now behind us” and that the recovery in the Euro area is “resilient” and “increasingly broad-based”. We think at the ECB’s June meeting, the governing council will remove language which says that the Euro area’s growth outlook remains titled to the downside or that interest rates may be at lower levels. Additionally, we expect the ECB to signal shortening the length of the QE programme and potentially begin normalising the deposit rate before year-end to avoid the risks that may be brought by the “temptation of gradualism in monetary policy”, as discussed last week by Benoit Cœuré – one of the most outspoken ECB board members – who shifted his tone from dovish to hawkish.

Fiscal Policy: More Upside in Europe, Uncertainty in the US

The US is likely to underdeliver on fiscal spending due to political turbulence. We see a low probability of President Trump being impeached in the near term, now that a respected independent counsel (former FBI Director Mueller) has been appointed. The investigation however, adds medium term uncertainty to the legislative process and makes it unlikely investors will soon forget how easily political turbulence can derail the administration’s agenda. In the short run, however, it should help refocus the debate back to de-regulation, tax reform and passing an expansionary budget.

Trump’s budgetary proposals appear unlikely to pass in their initial form given fiscal hawk opposition in both the House and Senate. Senate Majority Leader Mitch McConnell called for a “revenue-neutral” plan earlier this month, and important philosophical differences remain with House Speaker Paul Ryan’s preference for a border tax adjustment plan. Following the recent weeks of turmoil, we think the administration will be more amenable to compromise, which will likely imply a significant scale-down of the plan’s initially foreseen expansionary impact.

Europe and European politics are at a turning point – more fiscal spending could be on the way. Contrary to the US and UK, Europe has firmly rejected populists this year with Wilders in the Netherlands, Podemos in Spain, Hofer in Austria and, most recently, Le Pen in France. President Macron in France campaigned on a strong pro-European platform, and has since selected a centrist pro-European cabinet. We expect a Macron-Merkel Franco-German alliance to form, which should support EU-integration initiatives including greater fiscal spending and, potentially, a framework for fiscal transfers. McKinsey estimates €330bn in annual savings from the single market and currency, however exporting core-European countries may reap the largest benefit of this. While fiscal transfers will likely be politically challenging to pass, recently Germany’s Finance Minister Schäuble seemed to have softened his tone and spoke of converting the European bailout fund ESM effectively into a European Monetary Fund.

These measures will likely support growth and inflation in peripheral countries, which have lagged the rest of Europe. In addition, defense spending in Europe may continue to increase as well. Following President Trump’s criticism of Europe’s contribution into NATO expenditure, defense spending in Europe increased for the first time in 7 years last year. However, spending may increase further as Europe’s total defense expenditure was still around 1.47% of its GDP on average vs 3.6% for the US.

China: Walking a Tightrope between Growth and Deleveraging

Better near-term growth prospects for China have been a strong pillar of the global reflation theme over the past year, supporting commodity prices and EM assets. This is partly thanks to a series of mini-fiscal stimulus and relaxations of credit standards at the start of 2016, which had contributed to a housing market boom. However, the price of stimulus-driven growth is an even bigger debt pile, which we estimate at above 300% GDP now (private and public). Aware of the need to delever, the Chinese authorities have embarked on several rounds of policy tightening since late last year.

It is a fine art to deflate credit bubbles without choking off growth. Could China commit a policy mistake which in turn spill over into other economies? We think there is a risk: while China itself may have enough policy buffers to absorb a negative shock, other EM/commodity-linked economies appear vulnerable.

The Chinese government controls both the price and quantity of credit given a closed capital account, and there has been a tightening of both.

Interest rates: Market interest rates have risen as the PBoC fought the capital account outflows, with the benchmark 3-month SHIBOR at a 2-year peak vs flat policy rates. There has been a commensurate move in onshore bond yields, as the regulators have sought to delever carry trades in the local bond markets via the liquidity spigot. In March, the PBoC also increased its Medium-term Lending Facility and open market repo rates by 10bps for the third time this year. In other words, the tightening in interest rates is quite pronounced, but not yet at the 2011 levels when rates were hiked 125bp, causing the Wenzhou SME crisis and a substantial correction in Chinese risk assets.

Regulatory pressures and Macro-Prudential Assessment (MPA): Financial regulators have recently stepped up their rhetoric and actions against over-leverage, with the MPA framework introduced since 2016 and regulatory changes to entrusted loans being the most important measures. Entrusted loans are products where banks entrust part of their wealth management product (WMP) assets or proprietary funds to third-party asset managers, moving them off the banks’ own balance sheets. More than 90% of entrusted investments were in bonds with leverage (approximately 10% of China’s bond market) or equity. From Q1 2017, entrusted loans will officially be included in the broad credit growth figure, subjected to regulatory control. This change has already prompted redemptions and capital raisings among smaller banks, which are more reliant on entrusted loans and WMPs.

These changes have contributed to flattening out of loan growth in recent months, but have not yet translated into a slowdown. In our view, the government is likely to continue its light brake tapping on leverage, but not risk pushing the economy off a growth cliff. The key risk currently is that the new MPA framework may expose or trigger a liquidity issue in the non-banking financial institutions or a major disruption to the property markets, but we are not there yet.

Conclusions: The Reflation Trade Is Moving to Europe

1. Europe is at a turning point: inflation and growth could surprise to the upside. Following Macron’s victory in France, we think a Macron-Merkel Franco-German alliance is likely, which could mean greater Euro area integration including fiscal spending, stronger European institutions and eventually more opening to fiscal transfers. This is likely the start of a virtuous cycle, as inflation from greater fiscal spending may prompt a more hawkish ECB and higher rates, in turn supporting bank profitability, lending and growth in the Euro area.
2. The White House may under-deliver, but the market is complacent on the risk of a hawkish Fed. While growth in the US may stabilise, the market’s focus will likely remain on the risk of further disappointment on tax reform and fiscal expansion. We think the market is underestimating the likelihood that the Fed may hike in line with its projections, which are already shallower that previous hiking cycles. We think the market may be caught unprepared, with the most vulnerable being US HY credit and EM assets.
3. China is taking the foot off the leverage accelerator rather than tightening aggressively. However, trying to gradually deflate a credit bubble while maintaining growth is always a diffcult task. With its high domestic savings rate, foreign reserves and good liquidity in the formal banking system, China itself may have sufficient buffers in case of a potential policy error. Other China or commodity-linked economies could be more vulnerable.
4. Investment views: As we argued in February and in the last Silver Bullet, Europe is offering a more favourable economic and political backdrop to investors vs other developed economies. We think the reflation trend in Europe has further legs to go, and see the most value in the Euro, rates shorts and cyclical equities. We also think European credit is still attractive: while spreads are already tight, European corporates remain prudent on leverage, unlike their US peers. The ECB is also behind the Fed in the policy normalisation path. Still loose financial conditions and faster growth should reduce default risk and support further credit spread compression in the Euro area. In the UK we see rising risk of growth shocks and import-led inflation, as negotiations with the EU are likely to be tough, hurting Sterling and investment. This means a further squeeze on the UK consumer, property prices and a rising deficit. US assets appear rich, both in equities and credit. The major risk for the US is policy inertia and lack of delivery to the Trump administration’s promises, coupled with Fed tightening. Finally, we see some value in selective EM countries – the ones with limited exposure to oil and hard commodities, as we remain wary of compliance with the recent OPEC agreement and concerned about China growth.