Reflation causes rotation

Inflation is coming! At least that is the warning from prophets of doom since the central banks began to react to the credit crisis of the years 2008/09 with an unprecedented expansionary monetary policy. Until now, however, these warnings have always proved to be false alarms. Instead, deflationary or at least disinflationary tendencies were felt virtually worldwide in previous years. Only in the course of last year have the winds on the inflation front slowly started to change.

Recently, the inflation rate is picking up again, at least slightly. In the Eurozone the annual rate of consumer prices rose from 0.6 percent in November to 1.1 percent in December. On the one hand, this is still below the inflation target of almost 2 percent the European Central Bank has for the Eurozone, but on the other hand, it is the highest number since September 2013. In the U.S., prices were up 2.1 percent in the past year. That means annual inflation hit a 2-½ year high in December.

As in the case of almost all recent developments in the financial markets, it is said that the election of President Donald Trump has had at least a reinforcing effect. That has to do with his plans for a more expansive fiscal policy and the creation of millions of jobs. It is not only the U.S. national bank that thinks these proposals carry potential inflation risks. In fact, the economists at Capital Economics, not least for these reasons, expect that the headline and core CPI inflation in the U.S. will move up toward 3 percent this year.

Markets have already started to play the topic

Since it is not clear what will happen after one-time statistical base effects like a higher oil price run dry, it remains to be seen whether the outlined trends will really continue in 2017. It is striking, however, that over the past weeks and months, leading investment banks repeatedly published reports which contained reflation forecasts for the global economy. What is important here is that these predictions are not about strong inflation. Instead, according to Morgan Stanley Europe’s chief economist Elga Bartsch, the term “reflation” means a phase in which both growth and inflation are approaching their long-term trends again.

Noteworthy in this respect is the fact that the analysts’ forecasts are in line with recent developments in the financial markets. Consistent with the change in mood among investors and the rising inflation figures, particularly in the U.S., bond yields have risen. Bolstered by the key interest rate reversal in the U.S., the U.S. dollar is also showing continued strength.

In addition, strategists also link the stock market rally at the end of the year with the outlined development. According to Morgan Stanley, based on historic experiences, a reflation scenario is connected with the following scenario: Economic growth is recovering, policy rates remain relatively low, bond spreads are narrowing, and stock prices are picking up.

As Blackrock reported, at the turn of the year the accelerating reflation trend in the U.S. was the main theme with customers. In the discussions, the world’s largest asset manager held the view that reflation worldwide will accelerate in 2017, led by the United States and accompanied by rising nominal growth, wages and inflation rates. This theme also plays a central role in how Blackrock suggests positioning portfolios for the current year.

“With inflation taking root and growth picking up, we believe bond yields have bottomed, and yield curves are likely to steepen further in 2017. This environment should support reflationary beneficiaries, such as value stocks. Higher long-term rates drove a rotation within equities during the second half of 2016. Reflation contributed to value shares outperforming the broader market, as bond-like equities suffered. We expect more of this rotation in 2017, and see the stock market beneficiaries of the post-crisis low-rate environment further underperforming over the medium term,” says Richard Turnill. And the BlackRock global chief investment strategist adds, “We generally prefer stocks over bonds and are optimistic about further upward revisions to earnings estimates.”

Prefer real assets and stocks

In addition, fund manager Jupiter Asset Management believes that an environment with rising interest rates and higher inflation has a favorable effect on the prices of global financial stocks. This is also in line with the recent price movements on the stock market. Another interesting aspect is pointed out by Edith Southammakosane. Based on data since 1991, real assets tend to perform well during months of rising inflation in the U.S., with similar results also for Europe. According to Southammakosane, a multi-asset strategist at ETF Securities, the analysis shows that commodities are the best performer, followed by infrastructure, real estates and then inflation-linked bonds.

Bank of America Merrill Lynch also bets on real assets. In explaining that call, Chief Investment Strategist Michael Hartnett states that real assets were historically positively correlated with inflation and interest rates. Furthermore, real assets traditionally benefited from fiscal stimulus and protectionism. He also thinks real assets are cheap, since the long-run price relative of real assets to financial assets is at its lowest level since 1926. To implement the real asset theme, Hartnett recommends owning real estate, commodities and collectibles, either directly or through financial products like ETFs and specialized funds focusing on infrastructure, home building, precious metals, farmland, timber, wine, etc.

As far as stocks are concerned, this asset class is doing well as long as inflation does not get out of hand. This is shown in an empirical study by Sal. Oppenheim. Based on U.S. data, the capital market experts at the German private bank analyzed the real annual performance of six asset classes from 1900 to 2015. The aim was to find out whether equities, bonds, real estate, oil, cost and cash provide adequate protection against inflation and/or deflation. According to the results, investors lost money with stocks only in periods of inflation rates above 8 percent.

Taking these findings into account, it makes sense to incorporate the reflation theme when attempting to develop the appropriate investment strategy for 2017, especially since the financial markets have already started to play the reflation topic. However, in order for these trends to continue, the reflation scenario must actually unfold. For this reason, it will be even more important than usual for investors to pay close attention to the inflation data in the course of the current year.

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