All Aboard the Reflation Train?

Last week I warned of a tipping point in financial markets but also contrasted it with potential for a return of the reflation trade. Judging by the price action since, investors have opted to step back from the brink. The dollar finally has found some support—aided by PBoC intervention—bond yields have increased and stocks have rebounded modestly. One week does not make a trend, but the path toward a new reflation trade is simple. The dip in U.S. core inflation is temporary and political uncertainty will fade, prompting investors to focus on the bright side. If so, late-comers to the trend of a weaker dollar and lower yields are in for a rude awakening. By Q1, markets could be looking at a White House pushing through tax cuts; hurricane rebuilding will be underway—perhaps boosted by bipartisan support for infrastructure spending—inflation is rising, and the Fed has re-started its hiking cycle. I am not sure that I believe in this version of the world, but the implications are clear if you do. Bonds should be sold aggressively, the dollar is a buy—in particular against the euro and the yen—and domestic U.S. growth stocks, mainly financials, should be added to global equity portfolios. 

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All the Bogeymen are Here

I am tempted to use one of the most tired clichés to describe the state of play in financial markets. In his famous book with the same title, Malcolm Gladwell describes a tipping point as "the moment of critical mass and threshold" at which point the parameters and rules of the game—in a market or environment—change radically. As I peer across markets and economies, I am starting to wonder whether we are getting close to just that. The eye of the storm is quite literally the U.S. where the layers of economic and political uncertainty are now so thick that I am not even sure where to start. The tinfoil hat scenario goes something like this. The devastation of hurricanes Harvey and Irma is worse than feared and become a stagflationary hit—negative supply shock and plunge in demand—but the call for decisive action in Washington and the Eccles building go unheeded. The debt ceiling bites right when the economy needs the flexibility the most and the Fed is caught between a rock and a hard place as inflation soars. Pyongyang uses the confusion to show that it means business by firing a missile towards Alaska.

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Holding pattern

The portfolio finished August much in the same fashion as in the previous four months, stumbling to a monthly loss of about 0.7%. The dip extended the decline since May to a total of 1.1%—a far cry from the punchy +6.4% in the first four months of the year—and paltry compared with the MSCI World's +3.7% return in the same period. The numbers get even worse by adding currency effects. In a nutshell, your humble scribe has found himself on the wrong side of the contrarian trade of the year; the greenback's fall from grace. Accounts denominated in DKK and GBP with a lot of USD denominated investments have not been particularly friendly for returns so far in 2017. Speaking of which, traders' arguments about the dollar is reaching a crescendo and bucky has a decision to make. A few weeks ago I mused that if DXY broke 93 to the downside, punters would need to rethink their views. The DXY slipped to 92.5 towards the end of August, and I imagine many FX geeks are doing just that. The chart below shows that the dollar hasn't exactly crashed through support, so it still has time to step back from the brink, but it's getting sporty. 

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Is global liquidity now hostile for equities?

Last week I said that investors have plenty to worry about, but also that many of the traditional reasons to abandon ship—chiefly extended valuations and political paralysis and risk—perhaps weren't as valid as many think they are. The most convincing argument for not panicking despite extended valuations is that ample global liquidity and low interest rates remain as support for equities and credit markets. I imagine that his idea has been put down on page one of most investors' playbook since the financial crisis. The argument is pretty simple. As long as central banks are on the bid, their purchases of bonds—and other assets—will drive private investors into riskier markets. Known as the portfolio balancing effect, this is recognised to operate via both the stock and flow of central banks' balance sheets. Finally, front-end interest rates that are locked at the zero bound—or slow to rise even as the economy recovers—also translates into higher equity prices and tighter spreads. Low rates mean an increase in the future discounted value of cash flows and also encourages investors to pay a higher multiple for the same level of earnings. It also forces investors to seek out yield in private debt markets to reach their return targets, despite the higher risk profile of corporate bonds.

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