Reflation trades are ascendant


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The latest US and China trade headlines are scant on details and timing. No matter — equities are firmer, sovereign bond yields are higher (France’s 10-year yield turned positive for the first time since mid-July), while a firmer renminbi has bolstered Asia-Pacific equities and currencies. In other words, the reflation trade has air.

Thursday’s injection of hot trade air arrived from Beijing where Gao Feng, the commerce ministry spokesperson, told reporters that negotiators from both sides had agreed “to remove some of the additional tariffs in phases”. Rolling back tariffs has been a key demand from Beijing, so the market reaction was not unwarranted. But it does bear repeating that this kind of development had been expected and has been driving a solid rise in equities since early-October.

The MSCI Asia Pacific index has now climbed to its best level since August 2018, although it still lags the 2019 rallies recorded for equities in Europe and the US. Lately, global equities — with the Stoxx Europe 600 less than 2 per cent from its April 2015 peak — have pulled ahead of Wall Street (which is residing in record territory), indicating where trade optimism garners the biggest rewards.

Further upbeat trade tidings ahead of an eventual pact has scope to extend the current equity sector rotation, led by cyclicals or more economically sensitive sectors, while in regional terms, Asia and emerging markets also have scope to rally. A more broadly weaker US dollar and a firmer renminbi are crucial drivers for EM sentiment and will play a key role in sustaining this mood. A weaker dollar and firmer renminbi spur inflation expectations (the US and Germany on Thursday extended their now one-month long rebound). China’s onshore currency is now about Rmb6.9746 per dollar after crossing below the key seven level earlier this week.

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In turn, higher long-dated nominal bond yields bolster prospects for global financials and other cyclical sectors in equities along with smaller- and medium-sized companies. Bond traders continue to flag steeper yield curves with momentum being driven by leading eurozone yields setting new highs since they bottomed in mid-August. The US 10-year yield broke above 1.90 per cent on Thursday, even after Wednesday’s solid investor demand for the latest new Treasury benchmark sale. Thursday’s yield on the 10-year note was at its highest level since early-August when the market abruptly sliced through the 2 per cent barrier.

One rueful aspect about the long and winding path of trade negotiations is how the journey has featured numerous twists and dead ends. That should temper the enthusiasm of risk markets, but it also means that unexpected good news can spur a far more profound bullish reaction in equities. The respective leaders of the US and China need a win, and market sentiment likes the odds of detente with a bonus prize thrown in.

Wednesday’s note focused on how positioning (with many still lagging equity markets year-to-date) could well drive shares higher into year-end, while negative quarterly earnings growth was being downplayed.

As FT Markets noted here, active managers have missed the boat on Apple and other impressive old tech gains for this year. So the makings of a classic “fomo” (fear of missing out) trade remains high before a subsequent pullback. Beyond the likely prospect of performance-chasing as the year draws to a close, the rollback of tariffs between the US and China only really counts if business confidence and spending picks up in the coming months and nurtures, what is for now, equity market faith in a bigger reflation trade.

In Europe, investors on Thursday brushed aside weak German industrial output for September and downgrades for euro-area growth and inflation in 2020 by the European Commission.

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Mark McCormick at TD Securities observes “a notable gap between global growth tracking indicators versus other tools like financial conditions” but he also concludes:

“The former continues to paint a gloomy picture of global growth. Equities agree with the signal from FCI [financial conditions indices], which argues for some stability and then recovery in growth next year.”

Earlier on Thursday I enjoyed a coffee with Dean Turner, economist at UBS Wealth Management. He made the point that rolling back tariffs on their own won’t be enough to stimulate the economy. Markets need to see business confidence spur, too.

More broadly, the outlook for 2020, says Dean, rests on three elements: no recession, no sharp and sustained rises in government bond yields, and the right noises on policy, namely a push towards fiscal spending.

Under those conditions, Dean believes there is a “reasonable degree of optimism for good-quality companies” in equity markets next year.

But disappointment on that score will be brutal and there is no shortage of talk that faltering business investment may well have sealed the deal for a deeper contraction.

Albert Edwards at Société Générale makes that case via this chart and notes:

“Although in an economic recovery business investment contributes a fraction of GDP growth, in a recession the dotted line totally overlays the red line — business investment ‘causes’ recessions.”

Albert also reminds us:

“The US business investment cycle lags the whole economy profits cycle, so when profits are struggling, like now, the recession alarm bells should be ringing loudly.”

That’s quite a harpoon to puncture Thursday’s risk balloon, but proponents of the mid-cycle pause likely look at the 2015-16 soft patch for assurance. On that score, Albert has this warning:

“The false signal in 2015 was due to the collapse in shale oil and confined to only one sector.”

Quick Hits — What’s on the markets radar?

A Bank of England camped on the policy sidelines is not surprising as a general election beckons. The ultimate flavour of Brexit and what kind of fiscal stimulus eventually arrives next year are challenges for policy officials and Mark Carney’s successor.

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Before those big issues are defined, the BoE cut its forecasts for the UK economy in 2020 and 2021, with a notable cut in the near-term inflation outlook. Two officials, Michael Saunders and Jonathan Haskel, voted for a 25 basis point cut in the base rate due to Brexit uncertainties and the perception of a turn for the worse in the jobs market.

Rupert Thompson, head of research at Kingswood, says:

“The Bank is sitting on the fence and keeping its options open. While the risk of a no-deal Brexit has clearly fallen sharply, Brexit will remain a major source of uncertainty, and indeed drag, on the economy for a good while yet.”

In currency trading, the Japanese yen is under the pump as risk appetite picks up.

Adam Cole at RBC Capital Markets highlights that the yen has a close relationship with “general risk appetite” with its “rolling three-month correlation” with the S&P 500 (at 0.76) at its highest for five years.

Adam also notes this extends across other G10 currencies with respect to the yen or, “in other words, you can’t really have a view on JPY currently without having a view on risk”.

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