Back in late 2016 it seemed terribly simple. Growth and inflation would rise on the back of U.S. fiscal stimulus. Investors would buy cyclical companies, particularly U.S. small caps, and sell bonds. Four months later, the reflation trade, while not quite dead, seems less a sure thing. Cyclical commodities that soared in late 2016 have struggled this year. Commodities, the U.S. dollar and Japanese stocks are some of the worst performers year-to-date (see the chart below). At the same time those assets that faded as investors embraced reflation have rallied, including gold, emerging markets and the Japanese yen. Even low yielding European bonds have found a bid. What happened?
Markets got ahead of themselves
Many asset classes rallied as if a fundamental shift in the growth/inflation paradigm was a foregone conclusion. Investors assumed Washington would effortlessly churn out an assortment of pro-growth measures: tax reform, fiscal spending and deregulation. When the reality proved much harder, disappointment set in. Trades that were predicated on faster U.S. growth, such as a stronger U.S. dollar, have fallen the most. After surging more than 10% to a multiyear high, the dollar has retraced nearly half of the move and is back to mid-November levels.
Real economic data have not kept up with “soft data”
By now most have noticed the divergence between the “hard” data, which measures actual U.S. economic activity, and the “soft data,” which mostly tracks surveys. While measures of positive economic surprises have risen sharply, most of the improvement is from soft data. Job creation, wage growth, hours worked, retail sales and core inflation have all decelerated. Although the U.S. economy appears solid, evidence of a pickup remains elusive.
Many asset classes were stretched even before the rally
The rally in risky assets was only the latest in a bull market now comfortably into its ninth year. Many asset classes, notably U.S. equities, have benefited from years of rising valuations. Large cap U.S. stocks were already trading at 20x trailing earnings in July of 2016. The subsequent rally pushed the multiple up towards nearly 22x, a seven-year high. With the air coming out of the reflation trade, what should investors expect next? The good news is there is little evidence of a pending recession. The economy, both in the U.S. and globally, is solid with less deflation risk than a year ago. That said, investors will want to consider a more balanced portfolio, one that includes assets that offer income, from both equity and credit, equities tied to secular growth themes and even a bit of U.S. duration and gold. Markets are a bit less frothy than they were in January, but valuations are still elevated and volatility unusually low. And as we’ve seen, it is not as if the risks in the world have gone away.