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Contrarians sidelined by Trumpflation trade

Nobody likes to admit going along with the consensus. It sounds better to be contrarian, and in markets there is far more money to be made when you latch on to an unpopular notion that turns out to be correct. That is how you get to buy things cheap.

But sometimes the herd gets it right, even if it gets overexcited and “overshoots” its target. On balance, that is still the most likely scenario that faces us, after an astonishing two months in which markets have moved decisively to bet on a new spurt of growth, centred mainly in the US.

This has two components. One, obviously, is enthusiasm that the agenda of president-elect Donald Trump will be good for economic growth. The second is the belief that US growth is in any case picking up. These are reasonable propositions, and it behoves anyone wanting to make a contrarian bet to bear this in mind. That does not, however, mean that economic growth will necessarily be good for stocks in the short run, or that the market has not overshot.

The start of the new year has brought plenty of evidence of the state of the economy that Mr Trump is about to inherit. We know that dissatisfaction with stagnant earnings and with inequality is intense. However, the December unemployment figures show average weekly earnings growing at 2.9 per cent, almost a percentage point above the latest reading for core inflation (2.1 per cent). Both in nominal and real terms, this is the healthiest wage growth since the crisis. The gap between wage growth and core inflation has not been this wide in six years.

The numbers not even seeking work remain painfully high. Underemployment is dreadful. But demand for the pool of qualified workers that companies might waney to hire is now high enough to push up wages. This is good news for the working poor, and bad news for the central bank as it implies that inflationary pressure is building. The latest Fed minutes, published this week, suggest that central bankers know this, and are ready to tighten.

Will this doom the US to “stagflation,” or is there enough pressure to log some genuine growth? This month’s surveys of supply managers show rising business confidence, in the US and elsewhere, suggesting that the US economy is buoyant at the end of the Obama term. Consumer confidence is its highest in 15 years. Democrats might gnash their teeth that the election was not a few months later.

So a picture of US growth, despite the widespread discontent, is reasonable. Will it accelerate under Mr Trump? Uncertainty over what he will do is extreme. If the US goes through with tariffs and border taxes, a trade war could deliver stagflation rather than growth. But the deregulation agenda, and the aim for tax reform, should provide a genuine stimulus. So would a public infrastructure programme, but that looks harder to implement at this point, for reasons political (Republican deficit hawks dislike it) and practical (big infrastructure projects are difficult and take time).

On balance, then, US-led growth seems likely but not inevitable. Yields on long US Treasury bonds hit a historic low last summer, implying despair about growth prospects. That was overdone and created opportunities.

Does this mean every market move in the last couple of months has been justified? No. The rise in bond yields was spectacular, while the gain in stocks, already very expensive, made little sense. The move into equities was unsustainable, with almost $70bn moving into US equities since the election, according to BofA Merrill Lynch, while money flowed out of bonds, and non-US equities. As higher wages (eating into margins) and higher rates could hurt stocks even as the economy expands, the US stock market is ahead of itself, and driven by flows.

And risks continue to abound. The spread between the yields of peripheral and core eurozone countries is ticking up, in a sign of worry about this year’s European elections. China’s currency has moved wildly this week. And dollar strength could exacerbate problems for Mexico and Turkey, two large and currently troubled emerging markets whose currencies have dropped almost 15 per cent since the election to hit all-time lows.

All of this suggests that the re-evaluation of the reflation trade over the last three weeks, since the Fed signalled that it intends to raise rates three times this year, is sensible and healthy. There has been ballyhoo about the Dow Jones Industrial Average topping 20,000 for almost a month now. Bonds have recovered slightly.

Where does this leave an asset allocation decision? There is far too much uncertainty to be anything other than diversified. But for the short term, a lower holding of bonds than usual, while emphasising equities from outside the US, does seem reasonable. Contrarians have a chance to make more money if they are proved right, but for now the balance of evidence is against them.

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