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Capital Acumen Issue 33

Reflation Gaining Traction

Faster synchronized growth and rising pricing power have been reflected in a powerful bull market in equities that has surprised some investors.

Robert McGee Picture

Photograph by Andy Ryan

For about a decade, central banks have seen inflation fall short of their targets, and worried about their economies falling into the deflationary abyss last seen in the early 1930s. As a result, the Federal Reserve (the Fed), the Bank of England, the European Central Bank, the Bank of Japan (BoJ) and other developed economy central banks have resorted to unconventional tools like quantitative easing (QE) and negative interest rates to bolster growth and inflation.

Recent evidence suggests that this era of fighting deflation is slowly coming to an end, and the policy matrix will likely shift toward normalization over the next decade. The Fed has been a first-mover in this emerging trend, having begun its quantitative easing roll-off in October 2017. Still, just as fighting deflation took a long time, unwinding that fight will likely be a slow process as well.

One sign that reflation policies have started to bear fruit is a synchronized global acceleration in nominal gross domestic product (GDP) growth — with both inflation and real growth from a bottom that had threatened a deflationary relapse in early 2016. Another related sign is accelerating corporate-revenue growth. By October 2017, 45 countries tracked by the Organisation for Economic Co-operation and Development (OECD) were registering GDP growth, with 33 of the 45 showing accelerating growth, and OECD leading indicators pointed up. Economically sensitive prices, including those of copper and dynamic random access memory (DRAMs) as well as the Baltic Dry index, along with equity prices around the world, confirmed that global growth and reflation were indeed reawakening.

A man pulling air balloons

ManoAfrica/Getty Images

A New Market Environment

The emergence of faster synchronized growth and rising pricing power, for the first time in over a decade, has been reflected in a powerful bull market in equities that surprised investors caught up in the past decade’s “low growth, weak prices” mentality. In that situation, investors favored defensive stocks that did well in a low-interest-rate world (bond substitutes like utilities and real estate investment trusts, or REITs) or a weak consumer world (consumer staples). As reflation forces have gained the upper hand, however, those defensive areas of the market have underperformed, while stocks that benefit from stronger growth and higher interest rates (financials, industrials, homebuilding and materials) have outperformed.

This new environment also favors value stocks, and the fact that their underperformance has ended confirms the trending shift toward growth and inflation. Growth stocks were a major beneficiary of the low-growth, low-rate environment because of the premium put on each unit of growth and the long duration of their cash flows. Recently, some investors have moved away from high-flying growth names, especially the ones that are likely to see more intense regulatory scrutiny going forward, to previously under-owned underperformers that should do better in the years ahead.

"Stocks That Benefit From Stronger Growth and Higher Interest Rates Should Continue to Outperform."

With valuations relatively high in the United States compared with the rest of the world, money has also flowed out of the U.S. to places where the expansion is more embryonic, especially into emerging markets, where the potential for relative improvement is greater. Within the United States, valuations vary and correlations are lower, creating a positive environment for active management after a long stretch that favored passive management. This is even true within sectors where there is much more dispersion of valuations than before, as is typical later in an economic expansion. According to the Financial Times, the majority of actively managed U.S. equity funds beat their benchmarks in the first half of 2017 compared with the past decade, when passive vehicles tracking those benchmarks routinely outperformed the stock pickers. Given the late stage of the U.S. cycle and the valuation dispersion in the market, active management should do better as the reflation trade brings the previous laggards to the fore.

Election, Growth Favor Reflation

The reflation trade got a major lift from the U.S. presidential election. Investors saw the new administration’s pro-growth agenda as boosting fiscal stimulus, productivity, interest rates, inflation and GDP onto higher tracks. Early last year that hope began to fade, and the slow-growth, low-rate trade came back. As global growth continued to accelerate, and policy hopes reignited around tax policy, reflation trades have come back and appear poised to persist.

Borrowing Remains Slow

The National Financial Conditions Index reflects below-average nonfinancial leverage.

Graph representing national financial conditions

Sources: Federal Reserve Bank of Chicago; Haver Analytics. Data through Dec. 19, 2017. 

Indeed, signs that the United States is nearing the end of its expansion are few and far between. High business confidence is helping to rekindle investment, global trade is stronger than expected, and financial conditions remain very accommodative as inflation stays below target. Consumer fundamentals are very strong, making a sharp falloff in sales of durable goods such as autos highly unlikely. Households are less leveraged and have much healthier cash flows to service their debt, thanks in part to very low interest rates. Looking across the business and household sectors, it’s clear that the use of debt to fund demand remains below normal even in the ninth year of an economic expansion (see “Borrowing Remains Slow” above). This is unprecedented and, together with low inflation, points to a much-extended expansion cycle.

"Reflation Trades Have Come Back and Appear Poised to Persist."

Inflation is a key determinant of the cycle’s longevity. While leading indicators point to higher inflation this year, it would be coming off an unusually low level. Importantly, unit labor costs have remained very low and rising capital spending should boost productivity, helping keep those costs contained despite a tight labor market.

All in all, there is growing evidence that the U.S. economy is on its way to achieving a more normal economic performance, with higher growth and interest rates. After a decade of fighting deflationary forces, aggressive central bank action appears to have succeeded in ways that are still underappreciated because of their stealthy, slow-moving impact. Markets are leading indicators that embody the wisdom of crowds, and the markets see faster growth, higher inflation and rising interest rates in 2018.

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