It has been more than five months since President Trump’s surprise election victory infused new life into the eight-year-long US equity bull market. Global markets have behaved as many, including us, anticipated: equities, riskier corporate bonds and industrial commodities rose, while government bonds fell.
But the Trump administration’s recent failures to implement several campaign pledges led to the first speed bump in this ‘reflation rally’, casting doubt on whether it can continue. Investors are now questioning President Trump’s ability to make progress on critical aspects of the reflation story – implementation of corporate and personal tax cuts, business deregulation and increased infrastructure spending.
""We believe the reflation rally can run for a while longer""
We believe a US tax deal will be reached, but that this will take time, especially since the Republicans will be keen to ensure that there are revenue-boosting elements to any stimulus package. Therefore, while the US business cycle is in its late stages, we think the reflation rally can run for a while longer – and for reasons beyond the US.
Reflation is going global
The reflation theme seems to be broadening to other regions, with economic and corporate earnings growth estimates generally being revised higher, especially in Europe and Asia. Interestingly, the fiscal policy debate in Germany, which until now had led the euro area’s move towards greater austerity, also seems to be shifting back in favour of more easing. We are also seeing signs of a revival in Asian imports and exports, while Russia and Brazil are emerging from a couple of years of recession.
""Earnings growth expectations are robust and the pivot from economic ‘muddle-through’ to reflation suggests this is unlikely to change""
This bodes well for the medium term (6-12 month) outlook for equity markets, and as a result, global equities remain our preferred asset class. Earnings growth expectations are robust and the pivot from economic ‘muddle-through’ to reflation suggests this is unlikely to change dramatically.
The euro area is our preferred equity market. Valuations are relatively low compared to the US, while 2017 earnings growth expectations have risen against the backdrop of an improving domestic economic outlook and reduced fears of a trade war.
Favourable valuations in Asia
We are also positive on the outlook for Asia (excluding Japan) equities. Economic data is improving and the US dollar’s stability should be a positive as it means domestic policy settings can remain loose and the region could benefit from a pick-up in foreign portfolio inflows.
Valuations are reasonable, earnings are expanding at a double-digit pace and the region remains under-owned by institutional investors. Within Asia, India and China (especially the ‘new economy’ sectors) remain our preferred markets.
Within bonds, there is a clear preference for corporate bonds over government bonds and, particularly, for areas of the market that have less sensitivity to rising interest rates. This is because developed-market government bond yields are likely to move gradually higher as the reflation story unfolds and the US Federal Reserve gradually removes its accommodating policy. This is why we currently favour US floating rate senior loans and developed market high-yield bonds.
""While we do not predict electoral success for Eurosceptic parties, there are risks of temporary market volatility""
We are a little more cautious on Asian bonds. Issuers from China and Hong Kong have become increasingly dominant players in the Asian US dollar bond market. This exposes investors to higher concentration risks. Although China’s tightening capital controls and gradually rising interest rates have been successful in stemming outflows, any increase in concerns about China or reduced flows from Chinese investors could lead to sharp pullbacks in the market.
Cannot rule out short-term volatility
Of course, there are always risks of short-term weakness in equities and other riskier assets. While we do not predict electoral success for Eurosceptic parties, there are clearly risks of at least temporary market volatility as polls fluctuate. Also, some market indicators, such as implied volatility across different asset classes, do hint at investor complacency.
However, recent fund manager surveys show there is still significant cash sitting on the sidelines that has yet to be deployed into markets, which is usually an indication of further equity market upside.
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