It was in the summer of 2016, with the 10-year Government of Canada Note yielding 0.96%, that a new narrative was born, under the pretext of improving economic and inflation data. It planted the seeds of the now well established reflation trade. Prior to this, throughout the first half of 2016, the defensive sectors like telecoms, utilities, REITs and particularly bonds were some of the best performing sectors in the markets. That all rapidly changed throughout the summer of 2016 in what can now be identified as the key asset class and sector rotation moment of that year.
Source: Bloomberg Markets
The big winners were all anchored on the rotation into long U.S. dollars, long financials, long cyclicals and long emerging markets and/or long almost any high beta stock. This entire narrative was given a big boost of liquidity with the Trump victory and the herds of retail buyers who wanted a piece of the action. This reflation story has been easy to follow and easy to sell to an audience hungry for easy gains. Just one problem has developed. It has stopped working. Since the start of the year almost all the major reflation theme sectors have been stuck in the mud.
While the Canadian banks and energy stocks have begun correcting, giving back much of their early year gains, we rather are seeing the low beta, high dividend stocks performing very well. This includes gains in Government of Canada bonds, utilities like Fortis/Hydro One, telecoms like Rogers/BCE and REITs like the Canadian Apartment REIT and RioCan.
Drivers for 2017
Will the U.S. economy grow?
The U.S. economy has already been chugging along with structurally low unemployment largely attributable to unprecedentedly accommodative fed. This was fueled by a broad acceptance that the Trump administration will increase government infrastructure spending and provide stimulus with sweepingly broad tax cuts.
Yet, the realities are setting in that even for a great business man and negotiator, Trump is being bogged down with the almost dysfunctional political system that is almost completely void of bipartisan cooperation or even agreements within their own parties. What I will say with a high degree of confidence is that what Trump will ultimately be able to accomplish will be smaller, less impactful and much later for arrival than the market has priced in.
In addition to that, much of the bullish economic data, like the ISM, has now reached such high levels that there is little room for further gains. This would suggest that the boost the markets have been getting from improving data will now have to digest a period of normalization and retracement.
What will the animal spirits drive in investor sentiment when the punch bowl is empty and the reflation trade party starts to sober up?
The Federal Reserve Bank of Atlanta’s Center for Quantitative Economic Research regularly publishes their GDPNow forecast for the growth rate of real domestic product (GDP). Their current forecast is now at the lowest level of the year at a very subdued 0.60%, a far cry from any alarming reflation fear level.
Where are we in the business cycle?
In fact, based on data from the National Bureau of Economic Research, post WWII, the average American economic expansion has been 69.5 months. We are now going on 95 months in the current expansion making this the 3rd longest business cycle on record. Do you dare utter the words- “It is different this time because……”? Recessions not only happen, but more importantly, they are often induced by Federal Reserve tightening. Janet Yellen and the FOMC committee owe Donald Trump nothing. The recent surge in confidence and data gives the FOMC the window by which they can tighten without spurring on a negative reaction from the street which arguably was the primary obstacle for having not moved earlier.
Simple acceptance that this is the late stages of a business cycle. Now if you are hanging on the belief that main street analysts will warn you in advance of a turn in the business cycle, think again. In an Economic Letter from the Federal Reserve Bank of San Francisco titled: Persistent Over-optimism about Economic Growth, the authors state:
A famous Mark Twain saying of “History doesn’t repeat itself but it often rhymes”. If that is to be true, most main street analysts will once again miss the warning signs to the next economic contraction. If the data does start to slow and turn, the reflation trade will have to contend with new dis-inflationary forces that will derail the entire narrative.
What if nominal growth and inflation are more benign than expected?
- The Fed is raising rates
- The Bank of Canada is walking a tightrope with monetary policy in the midst of a real estate bubble in some of its biggest cities
- The growth of the money supply is contracting
- The velocity of money is slowing
- Loan creation is slowing
- The Fed has made it known they will start to shrink its balance sheet
What fiscal or demographic forces can offset such monetary policy conditions? While these conditions alone do not guarantee a recession, it is important to simply accept, the accommodative central banks of the last decade are gone and now the economy is going to be left to see if it can swim in the choppy waters without the central bank water wings.
Recession or not, do you really want to bet that this is the backdrop behind rapidly rising growth and inflation?
How to Trade It?
I will stand by my 2017 forecasts that being positioned in longer duration government bonds, low beta, non-financial high dividend paying stocks like telecoms and utilities will fare much better than the main street analysts suggest. Though short-term rates will likely go higher in the U.S., it continues to likely be a yield curve flattener trade.
What to consider regarding investors holding the reflation trade stocks like - cyclical high beta and financial names?
In short summary …. Buy protective puts to lock in your gains.
It has been a great run, just reflect back to all the past market cycles you have invested through, when you have seen material paper profits made and subsequently be given back without taking action. Is it not worth a few dollars profit to hedge those gains?