Investment theme #4 - Equity sector strategy: reflation trades

  • Written by 
  • 14/12/2016

A turbulent period for bond investors, amidst returning inflation and fears/hopes of an inflationary incoming US administration, has proven a boon for some of the more cyclical areas of the equity market. Banking, industrial and technology stocks are part of the driving force that has taken the US stock market to fresh all-time highs. Few details on policy and implementation have emerged from a still inchoate Trump administration. Whether President-elect Trump can, or even wants to, keep his promises and threats, and how far-reaching the resultant policies are, depends in large part on Congress.

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Nevertheless, the case for leaning equity portfolios to the more cyclically sensitive areas of the market, even after the recent sharp rally, remains powerful. The base effect driven bounce in inflation data has helped to reverse overly-pessimistic assumptions on long-term inflation since the summer (Figure 12). Meanwhile, a less historically remarkable term premium should start to emerge in bonds as developed world central bankers take their feet slowly off the monetary pedal over the next few years. This, in turn, should relieve some of the strain on bank net interest margins, providing much needed succour to a still widely distrusted sector. Meanwhile, we see a rising yield curve as indicative of improving expectations for growth, something echoed by the ISM, and other manufacturing surveys. Such improving confidence is also consistent with higher earnings expectations, particularly from the more economically-sensitive areas of the stock market.

For banks specifically, loan growth and credit quality have been solid in the developed world, with loans to households now growing at a stable pace (Figure 13). The clearest investment case for banks remains the US segment, where inflation expectations are most credibly rising amidst rising wages. The case for European banks is obviously more cluttered, with a more questionable backdrop for growth and inflation and a structurally more concerning non-performing loan backdrop. However, the potential upside is likely greater too given depressed valuations. The valuation upside is admittedly less obvious for the likes of technology and industrials, but, as noted above, we see market-beating returns spurred primarily by above-average earnings growth in these areas.

This reflation trade predates President-elect Trump’s surprise election win and does not rely on some of his more growth-friendly policies making it through Congress. We see yield curves continuing to rise and steepen as the forces of growth and inflation in both the US and world economy prove themselves less structurally absent than widely feared.

With banks at the epicenter of the last, harrowing, recession, they were always likely to be the last sector to recover. The macroeconomic environment has not been helpful, with slow growth leaving flat bond yield curves and central bankers desperately experimenting with negative deposit rates. However, the above-mentioned more helpful economic backdrop is likely to scoop up some of the more cyclical areas of the market with banks. For this reason we advise clients to lean equity exposure in portfolios towards financials, technology and industrials.