With US stock markets hitting record highs last week, the question has to be asked. Has the Trump reflation trade — long in equities, short in bonds — run its course? In the equity market it has been a crowded trade for quite some time. On the bond side, futures market data are telling us that there are exceptionally large speculative bear positions in the market. This spells danger and the possibility that Treasury yields could tumble back down to levels seen last year. Yet it may be premature to expect an about-turn.
Much will hinge on the news flow about the Trump Administration’s tax reforms; likewise on monetary policy, where it is not inconceivable that the Federal Reserve will tighten faster than the markets currently expect. We may learn more when Fed chair Janet Yellen and vice-chairman Stanley Fischer speak later this week. The important point, though, is that the reflation trade is now as much a global as an American phenomenon.
The recent rise in copper and steel prices is a clear indication of a global upturn in growth and inflation. That is partly a story about China where last year’s huge fiscal stimulus drove higher than expected growth and where consumers are now joining the party. And the flow of money into emerging markets since the start of the year suggests that investors are more impressed by the prospect of renewed growth there than they are worried about the heavy dollar debt overhang.
Perhaps the most interesting positive story for the markets concerns the eurozone.
While investors have been mesmerised by the outflow of funds from the French to the German bond market as National Front leader Marine Le Pen’s poll ratings improve, the eurozone has finally emerged from its deflation. On the latest numbers no member of the eurozone was still in deflation in January. At the same time the flash estimate for the fourth quarter showed year-on-year GDP growth of 1.7 per cent, not far short of the US rate of 1.9 per cent.
As well as enjoying the benefit of an undervalued currency, the eurozone has seen stronger private consumption, helped by the windfall from lower energy prices. With business confidence picking up and bank lending increasing the recovery looks set to broaden.
Of course there are snags, most notably the rise in populism in a year which sees elections in Germany, France and the Netherlands. At a more fundamental level the European Central Bank’s quantitative easing has bought time for much-needed structural reform which the politicians have failed to deliver. The eurozone, lacking the burden sharing infrastructure for a successful monetary union, seems doomed to stagger from one crisis to another. After years of political and economic stasis, Italy rather than Greece looks a potential catalyst for the next upheaval.
Perhaps the biggest threats to the continuation of the Trump reflation trade are protectionism and geopolitics. On foreign policy, it may be that the president’s bark (or tweet) is worse than his bite. Geopolitical ups and downs are also inherently unforecastable. But the protectionism is real and may provoke retaliation that will be bad for global growth and especially bad for emerging markets along with countries such as Japan, South Korea and Germany where growth is heavily reliant on exports. That said, President Trump may succeed in doing what vested interests have hitherto prevented Xi Jinping, his Chinese opposite number, from achieving — namely, rebalancing the Chinese economy more convincingly away from exports and investment towards consumption. Given the impact of tariff barriers on import costs, he could also rekindle an inflation that might force the Fed to return to something closer to normal interest rates.
The more direct problem for investors in equities and bonds is simply that the current historically high level of markets ensures low future returns. In their annual survey of investment returns for Credit Suisse Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School provide convincing evidence that low real interest rates mean a low return world for both equities and bonds. Their estimate for the long run equity risk premium over the US Treasury bill return is 3-3.5 per cent, which is lower than many have assumed in recent decades. So be warned that the Trump reflation trade is clearly about momentum, not value.