Since last summer, when evidence of China’s economic stimulus started to come through, global markets rose on hopes of a rise in global growth and a return of inflation – the “reflation trade”. It gained impetus when Donald Trump was elected, because he was expected to implement tax cuts and increase government spending. But after world stocks hit a series of new peaks earlier this year, some air has started to hiss out of the reflation balloon.
Markets have reined in their expectations of inflation over the next five years in America, Britain and Germany, while Japanese equities have relinquished their gains for 2017.
US small caps, listed firms worth between $200m and $2bn, were expected to be the main beneficiary of the Trump tax cuts and stimulus, as they are less exposed to overseas growth and lack the “sophisticated strategies that bigger companies use to cut their tax bills”. They have slipped sharply of late.
A key reason for the newfound caution is that confidence in Trump’s ability to push legislation through Congress has suffered a blow since his healthcare debacle. Moreover, “after months of pleasant surprises, the data is no longer running ahead of expectations”, says John Authers in the FT. The March US employment report was weak, while last week brought news of a drop in core inflation (minus volatile food and energy prices) – the first for seven years. The annual headline rate slipped back to 2.4% in March from 2.7% the month before.
Still, it’s too early to write off the reflation trade. As several analysts have noted, the slide in inflation was due mostly to one-off factors, such as a sharp decline in mobile-phone service charges and petrol prices. Deutsche Bank points out that if you concentrate only on items in the inflation basket whose prices change less often than the median item’s 4.3 months – the so-called “sticky” CPI series – then the inflation rate has barely budged from an annual rate of 2.5% for 18 months. A similar calculation of eurozone consumer prices hit a three-year high last month. “The rising global inflation trade remains intact.”
The economic data may not be exceeding expectations as much as it was earlier this year, agrees Authers, but it has “remained robust”. The slide in market confidence seems overdone, and would probably reverse if oil, always a key ingredient of the inflation story, stabilises again. “A second trigger is policy”: a “meaningful tax cut” from Congress would also provide cheer.