The reflation trade is back, in earnest.
On Wednesday, all-world stock indices traded at all-time highs for the first time since spring 2015. US 10-year bond yields rose back to 2.5 per cent. Bank stocks rallied, with Goldman Sachs at an all-time high for the first time in a decade. So did tech stocks — Apple is back at a record. All of this after a hawkish appearance before Congress by Janet Yellen which might until recently have been expected to scare the markets. And all of this as political uncertainty rises, with President Donald Trump already in the midst of a serious scandal while populists attempt to take power in elections due across Europe.
This is, at the least, a vote of confidence in global reflation. What it is not, although it might appear that way, is an emphatic vote of confidence in President Trump. This is not all, or perhaps not even mostly, about him.
So far, the messy start to the new administration has not even touched on the corporate and economic agenda that matters most to corporate America. Earnings season for the fourth quarter of 2016 is winding down, and executives have made clear what they want in answering questions from investors. As summarised by Goldman Sachs’ equity strategist David Kostin, they want tax cuts and reform, deregulation and infrastructure spending, while most of them are scared about the possibility of a trade war.
With the exception of promises to look afresh at Dodd-Frank banking legislation, there has so far been no action on any of this. The series of alarms provided by the new team at the White House have not, as yet, given any reason either to take the Trump Trade forward, or to give up on it.
The catalysts for the latest leg in the reflation trade lie elsewhere. First, earnings season has passed off without a major hitch. According to Thomson Reuters, S&P 500 earnings are on course for a year-on-year gain of 7.2 per cent, on the back of sales which have grown by 4.3 per cent. This is the first quarter in a while where the big fall in oil prices has not skewed year-on-year comparisons. Energy sector earnings are up 2.4 per cent, while the rally in financials, with profits up 11.6 per cent, has driven the market.
As the biggest sectors in all-world indices are financials and technology (also buoyed by strong results), this explains the latest rally. Banks’ profits benefit directly from higher rates; but rates are still too low to threaten serious damage to other companies’ profits.
As for valuations, this peak does not look any more stretched than the last one in spring 2015. Using the MSCI indices, the all-world’s price/earnings multiple has moved from 19.3 to 22.1 in that time, but this is almost entirely driven by the US, which is at a p/e of 23.5 and now accounts for more than half of the world. Book multiples remain unchanged, and world equities are actually yielding slightly more than they did at the last peak. The US looks overpriced at 2.8 times book, but not so the rest of the world, which is valued at 1.68 times book value.
Next, there is China. It was credit stimulus in China that started the rally in world stocks about 12 months ago, and the latest data have provided some reassurance that the Chinese economy is not about to fall. Morgan Stanley this week published a huge research report entitled “Why we are bullish on China” which accurately captures the mood.
Finally, data have been beating forecasts the world over. Citi’s closely watched economic surprise indices, which rise and fall depending on whether economic data releases are above or below forecast, have in the weeks since the election risen to their highest since 2010. That resurgent confidence in growth cannot be lightly dismissed.
That said, the growth of the overall indices conceals huge variations between sectors and countries. The world as a whole may be at a new record, but the world outside the US, according to the FTSE indices, is still 24.6 per cent below its high from 2007 and 10.8 per cent below its most recent peak in 2015.
As has been true for years now, the US looks expensive, and much of the rest of the world looks cheap. Those wanting to join in with the investors who are placing their chips on reflation — and who lack full confidence in the Trump administration to deliver on its economic agenda — should look for stocks outside the US.
