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Think the reflation trade is done? Not according to BofA ML analysts

25 September 2017

Analysts at Bank of America Merrill Lynch think the ‘reflation trade’ that boosted markets at the end of 2016 could soon make a reappearance.

By Gary Jackson,

Editor, FE Trustnet

Markets could enjoy another rally in the final quarter of 2017, according to strategists at Bank of America Merrill Lynch, as the ‘reflation trade’ seen at the end of last year comes back into play.

Despite surprise events such as the UK’s vote to leave the EU and the election of Donald Trump as US president, 2016 ended up being a fairly strong one for equity investors, with gains posted by most indices.

As the chart below shows, global equities (reflected here by the MSCI World index) were up by 28.24 per cent in US dollar terms even after going through a challenging start to the year. Investors began 2016 with a nervous mindset, owing to concerns about deflation and weak Chinese economic data.

Performance of indices during 2016 in local currencies

 

Source: FE Analytics

For many of these indices, the gains came in the latter half of the year when it became clear that the risk of deflation was receding and inflation started picking up in many parts of the globe; additionally, Trump campaigned on promises to spend heavily on infrastructure, which would have a reflationary effect.

FE Analytics data show that the MSCI World index, for example, made a 0.66 per cent total return in the opening six months of 2016 in dollar terms, but then made 6.81 per cent in the second half.

This trend petered off early in 2017 though, with the growth style returning to dominance and value/reflation stocks starting to lag once more. This led some to argue that the reflation trade was short-lived and suggest investors stay away from riskier, more cyclical areas of the market.

In a recent note, however, Bank of America Merrill Lynch (BofA ML) strategists James Barty, Ronan Carr and Tommy Ricketts argued that it might be “time to dust off some of the Trump/reflation trades into year-end”.


“Sometimes we feel like a broken record going on about the synchronised recovery and what it means for markets – equities in particular,” they wrote. “This has very much been a reluctant rally. Investors think it is late cycle … and have been unwilling to put too much risk into their portfolios.

“It's one reason why [BofA ML chief investment strategist] Michael Hartnett's bull-bear indicator has been struggling to get into sell territory. Even last month when cash levels fell, portfolio protection rose to a 14-month high. Investors don't trust the rally.”

The bull-bear indicator that the strategists mention is from the recent BofA ML Global Fund Manager Survey; it looks at six measurements of sentiment: hedge fund positioning, credit market technicals, equity market breadth, equity flows, bond flows and long-only fund positioning. A reading of 8.0 indicates ‘sell’ signal but it remains in ‘buy’ territory at 7.0.

High equity valuation mitigated by high cash weighting

 

Source: BofA ML Global Fund Manager Survey

The strategists pointed out that this investor caution comes at a time when the global economy is looking in relatively good shape: purchasing managers indices (PMIs) around the world are high and global growth is expected to be 3.6 per cent for this year and next.

“And yet the ‘reflation trade’ has not really worked this year with the US dollar and bond yields falling. We put this down to positioning – it had got really stretched this time last year, together with relative growth and inflation trends,” the note said.

“Growth has picked up more strongly in the rest of the world, relative to expectations, than it has in the US, where hopes were high based on the expected fiscal stimulus. Meanwhile it is US inflation that has surprised most on the downside. That took the steam out of the US dollar and lower inflation meant bond investors were able to start to ratchet down rate expectations.”


But Barty, Carr and Ricketts said they expect this year’s inflation weakness to start reversing. This is in line with the thinking of the Federal Reserve, which last week reminded investors that it will continue to tighten monetary policy.

With this in mind, BofA ML said that the US dollar is one trade that would benefit from the pick-up in inflation as this would support the view that the Fed will continue to lift interest rates in the US.

This would also strengthen the investment case for short-duration equities, or those with more sensitivity to interest rate movements. BofA ML’s analysts favour US banks but note that other cyclicals could also do well.

“If rates have indeed seen their lows for the year then we think banks in particular can have a run. In a global context we prefer US banks as rates are likely to move faster in the US and regulatory reform is a bigger driver,” they wrote. “And our US strategists note that if payout ratios start to rise as we expect then the market has normally put a significantly higher multiple on banks.”

Probability of a December rate increase by the Federal Reserve

 

Source: BofA Merrill Lynch Global Research, Bloomberg

Outside of the US, they said that European and Japanese equities are areas likely to benefit from a reflation trade, more so than emerging markets (EM).

“While we remain upbeat on EM and fully agree with … structural bullishness on the area, we think Japan and Europe have potential for a stronger run into year-end should the US dollar behave as we think,” they said.

“Positioning in both has come down from the highs of earlier this year, yet fundamentals for both remain strong. Domestic growth has remained solid in both economies and that will continue to support earnings. Meanwhile both central banks have committed to either maintaining their dovish stance (Bank of Japan) or exiting as slowly as they can (European Central Bank).”

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