Too early to call time on the reflation trade

Over the last six months, equities have been driven by a “Roaring 20s” narrative, marked by higher economic growth combined with moderately higher inflation and interest rates. This supported stocks, particularly those exposed to reflation. But in recent weeks, that narrative has given way to one of “secular stagnation”—low growth, low inflation, and low rates. Since the June FOMC meeting, the S&P 500 has gained 2.5%, but US Treasuries have also rallied. Energy and financial stocks have fallen 11.9% and 1.6%, respectively, while tech has risen 6.2%.

Several things appear to be driving this shift:

• The idea that high rates of inflation may force the Federal Reserve to hike interest rates prematurely, curbing future growth;
• the fear that the spread of the Delta variant might disrupt the global economic recovery;
• and the concern that policy changes and slowing growth momentum could undermine sentiment on China.

In our latest Monthly Letter, we address key questions we’re getting from investors in light of this shift in narrative:

Concerns that premature Fed tightening or the Delta variant could derail the economic recovery are overdone.

• We share the Fed’s view that inflation is transitory and will ease as pandemic-related disruptions clear and base effects dissipate. We don’t think near-term inflation will force policymakers to over tighten, and the Fed’s employment criteria are still unmet. While the Delta variant may mean a more uneven economic recovery globally—with some emerging market economies on a slower path to reopening than the US and Europe—vaccines appear to be effective at reducing healthcare burdens, and we expect governments increasingly to look through rising case numbers.

The reflation trade has further to run.

• Strong consumer balance sheets and the need for businesses to rebuild inventory and capex should sustain economic momentum and corporate earnings. We expect 40% growth in S&P 500 corporate earnings in 2021, and we think consensus forecasts for 10% growth in 2022 are likely to be revised upward. We remain positive on risk assets, expect the 10-year US Treasury yield to rise in 2H21, and continue to advocate positioning for reopening and recovery. We still favor energy and financial stocks, as well as emerging market equities.

Asia continues to offer opportunities, though a more selective approach is warranted.

• We retain our regional tactical preference for Japanese stocks, and believe the market is well-placed to reverse its recent underperformance as an accelerating vaccine rollout facilitates reopening. A weaker yen should also lend support, and we forecast 40% earnings growth for MSCI Japan companies in the fiscal year to end-March 2022.
• We are shifting our tactical stance on offshore Chinese equities to neutral within our Asia strategy, given the extent of recent regulatory action against tech companies. With roughly 50% of China’s offshore index tilted to new economy names, we see less scope for relative near-term outperformance until there is a clear catalyst or a signal that the current regulatory cycle is easing. However, we believe the medium- to longer-term earnings prospects for China’s new economy sector remain positive, especially for themes relating to the digital economy and the Next Big Thing.

So, in short, we do not believe the underlying data supports the “secular stagnation” narrative at present. Read more in our Monthly Letter, “Bond vigilantes.”

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