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Global reflation trade is in need of fresh impetus

Not everything is Donald Trump’s fault. And by the same token, not everything that goes right in the world can be attributed to him.

It can be difficult to remember this, particularly in the US where domestic politics is crowding out almost everything else from the news, and where most people are inclined to view the news through stridently pro- or anti-Trump lenses. Mr Trump seems so prevalent that it seems natural to attribute all market moves to him.

As this column has pointed out before, this was never strictly accurate. The “Trump Trade” was a genuine phenomenon alright; the way US stocks, and more generally all securities that might benefit from reflation, accelerated after he was elected last November leaves no doubt of that. But a global “reflation trade” had already been at work for several months by the time of the election.

Bear this in mind when assessing the market impact of the impasse over healthcare reform. Thursday’s stock market action plainly took cues from Washington, with the S&P 500 dipping sharply on the House Freedom Caucus’ announcement that it would vote against, and again when the cancellation of the planned Thursday night vote was announced. But it closed the day almost exactly where it started, and US stocks remain near all-time highs. This has been a bad week, but nothing exceptional.

Meanwhile, note two very important shifts in the reflation trade. First, it is no longer an “America First” trade. From the election until the turn of the year, the US starkly outperformed the rest of the world. Over the past two weeks, that gap has almost been made up. European stocks, if measured by the FTSE-Eurofirst 300, have now slightly outperformed the US since the election. Emerging markets have also outperformed the US of late, and have nearly made up all their lost ground.

Second, inflation expectations, the critical driver of a belief in reflation, are beginning to fall. These can be derived from the difference between the yields on inflation-linked and fixed-income bonds — the gap represents expected inflation. In the US, 10-year break-evens shot up after the election, and have stood at 2 per cent (the Federal Reserve’s target) or just above for three months now. This week, they have slipped slightly below, to 1.97 per cent. German longer-term inflation expectations have also fallen after a significant rise. Two-year expectations, sensitive to the recent fall in the oil price, have fallen by more. This is not a reversal of the reflation trade, as of yet, but it is a clear sign of nerves about it.

The schema used by Atul Lele, investment strategist at Deltec, is useful for analysing why. Ultimately, he says, world markets are moved forward by two factors — global growth momentum and liquidity. When these factors are working in your favour, there is only one factor that can mess them up; politics.

Mr Trump’s election, he points out, was the most dramatic of a series of moments that aided growth momentum. Others included China’s move to start stimulating its economy last year, Japan’s latest attempts to revive its economy, or even the election of Justin Trudeau in Canada. The US election came just as a number of leading economic indicators the world over started to show sharp improvement, reflecting a belief that excessive reliance on monetary policy was giving way to fiscal stimulus. That showed up mostly in confidence surveys. Meanwhile, central banks are still making money plentiful in much of the world, and even the Fed, after its hikes, is not setting rates at a level that inhibits economic growth. There is money around.

Meanwhile (outside the US where Mr Trump seems to be in difficulties), the political news has been generally market-positive.

Most apply primarily to the world outside the US. First, political risks in the EU are perceived to have fallen significantly since last week’s election in the Netherlands, which saw a reverse for the populist Geert Wilders.

Second, liquidity is flowing back towards parts of the world that had lacked it. According to EPFR, US mutual funds lost $9.1bn in outflow over the past week, the world’s worst performing region, while global emerging markets funds received $3.1bn.

Third, policy divergence is not as wide as once feared. The People’s Bank of China raised rates a day after the Fed, and the Bank of England and the European Central Bank have both suggested that they are closer to tightening money than most had assumed. Meanwhile, the gloss that Janet Yellen, the Fed’s chairwoman, put on last week’s rise in rates was interpreted to mean that the Fed is not racing ahead to raise rates as had once been assumed.

The chance of three rate hikes this year has been pulled back by more than 10 percentage points over the past week, as measured by the futures market, and it is now perceived as an almost exactly 50-50 shot. This matters because it means the dollar is no longer running amok, as looked possible three months ago. It has fallen noticeably since then, particularly against emerging market currencies.

All of this helps emerging markets. They no longer have to contend with funds flowing towards the US (a liquidity issue), and the risk of problems servicing dollar-denominated debt has reduced. Their growth prospects look better, so EM is doing well.

What of the final element, of political noise? There was a nasty run on emerging market currencies in the two months after Mr Trump was elected. This reflected the belief that he was going to raise the drawbridge and limit trade, a policy that potentially spelt disaster for the emerging world.

But during the excitement of his two-month presidency, he has so far done nothing to rein in or limit trade agreements that were already in place. It appeared quite possible that the US would already have embarked on a trade war with China by now, and this has not happened. Even the Mexican peso has recovered nicely. So the balance of political risks again has favoured the emerging world.

But now we have to return to politics in the US. The healthcare reform in itself is not particularly salient to markets. The plans for fiscal stimulus through tax cuts or infrastructure spending are far more important. But a serious breakdown over healthcare would send the message that Mr Trump could not command a congressional majority, largely because a significant group of Republicans want him to be more aggressive in cutting back fiscally.

Recall that back in November, a Trump victory was expected to send markets down. One of the chief reasons it did not was that investors were startled to see that he had solid majorities in both houses of Congress. That led them to mark up considerably the chances of fiscal spending. A failure over healthcare would suggest that the chance of a big fiscal boost needs to be marked down. That would certainly trim the profits from the Trump Trade.

So the world has now reached this juncture; reflation seems to be on course, but the fall in inflation expectations shows that there is now some anxiety to see more growth show up in hard data; any rebalancing of the world economy seems less likely to favour the US over everyone else than before, sending liquidity back towards the emerging markets; and the greatest risk of something to blow this off course comes as ever from politics, not just in France but also in the US.

As the US stock market has outpaced the rest of the world ever since the great financial crisis, it seems sensible to expect the rest of the world to continue to catch up. For this we cannot blame Donald Trump; indeed he deserves some credit for it. If his agenda goes seriously awry, that will deliver a much sharper jolt to the hopes of reflation — and it will be fair to hold him responsible.

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