On Wednesday, the Federal Reserve raised interest rates and re-emphasised its view that interest rates will rise two more times during 2017. What surprised a great many commentators is that the dollar fell on the news. Ordinarily investors will find a currency more valuable as the interest which can be earned on deposits held in that currency go up.
There were a few other market reactions to this news. Long-term interest rates fell. What this reflects is that short-term investors had become fixated about the prospect of higher inflation, higher interest rates and a stronger dollar. Long-term rates came down not because there was anything particularly downbeat about the Fed’s comments but because the rates had been heavily distorted through speculation from short term investors such as hedge funds and traders.
This has become wrapped up in the concept people call “the reflation trade”. This is an expression that essentially encapsulates what will happen if investors start to bet on higher economic growth and inflation.
The election of Donald Trump was seen as yet more vindication of that same theme (some people call it the Trump trade).
We tend to be sceptical of fads like this. There are lots of quite reasonable underpinnings of the investment stories the reflation trade promulgates, but there are others which are far wide of the mark.
Moreover, when a large number of investors find themselves positioned for the same outcome, it becomes mathematically more likely that the opposite will happen. We are therefore a little sceptical about over-buying the US. While we are overweight US in many of our equity portfolios because we believe the growth story is strong, we also believe some investors are getting carried away.
That said, the news from America, which is at the epicentre of the reflation trade, is good. Citibank produces a well-followed index of economic surprises which is at its highest since 2013. The index rises when economic data exceeds the economic consensus forecasts, and this tends to support equities.
In addition, inflation is indeed rising, but a lot of this is to do with the fact that energy prices have more than doubled since this time last year. Underlying inflationary pressures are present but wage growth remains fairly modest. What matters more than the trends in growth and inflation are the drivers of those trends. We have to be looking forward to what will happen rather than commentating on what has happened.
The global economy has seen a coincident improvement in economic performance. To identify this as being a result of the change in US President requires a huge leap of imagination (especially when some of the President’s rhetoric is antagonistic towards other countries).
The improvement is in fact due to a big boost to real incomes (that is, incomes that have been adjusted for inflation). Because oil prices fell so much between 2014 and 2016, thereby reducing inflation, consumers’ disposable incomes rose.
But because oil prices have risen again since last year, that pace of disposable income growth has fallen back to nil. Make no mistake, oil prices are still around half of what they were two years ago, so consumers and non-oil related businesses should be enjoying a joint benefit. But the impact is a little less than it was last year.
With that in mind, while we remain positive on the pace of US economic growth and its impact on equity markets, we also think there is excessive enthusiasm for certain aspects of the reflation trade.
What strikes us at the moment is that there appears to be more value in areas which are not quite so heavily trodden by the investment crowds, such as Europe, the Far East, or indeed here at home in the UK.
Guy Foster, Head of Research
Guy leads Brewin Dolphin’s Research team ensuring that a rigorous and exhaustive investment process is employed. He also provides recommendations on tactical investment strategy to Brewin Dolphin’s investment managers and strategic recommendations to the group’s Asset Allocation Committee. Before joining Brewin Dolphin in 2006, Guy was an Investment Director at Hill Martin (Asset Management). Guy has a Masters in Finance from London Business School. He is also a CFA charterholder, holds the CISI Diploma, and is a member of the Society of Business Economists. Guy frequently discusses financial issues with the written and televised media as well as presenting to the staff and clients of Brewin Dolphin.
If you invest in currencies other than your own, fluctuations in currency value will mean that the value of your investment will move independently of the underlying asset.
Investments can rise and fall so you may get back less than you invested.