Why 2018 could be the year of reflation
Schroders Live: Keith Wade and Michael Scott discussed reflation, commodity prices and political developments in the US, as well as where to find opportunities in the current market environment
The outlook for the global economy is positive as we start 2018, according to Keith Wade, and he expects the result to be inflationary.
“We upgraded our forecasts in November, but if we were to do the work now, we would likely be upgrading our expectations once again”, he said.
“In Europe, economic activity is particularly strong and records are being broken: we are seeing higher purchasing managers’ indices, improving business surveys and rising capital spending.
“Meanwhile, in the US, there are signs that inflation is beginning to stir.”
The year ahead will be quite different to the one that just ended, he thinks.
“We believe 2018 will be characterised by reflation, rather than the “Goldilocks” world of 2017, where activity and inflation was relatively subdued”.
Rising commodity prices will help reflationary momentum but not “derail the world economy”, according to Wade.
He pointed out that the US shale gas industry is the most critical player in terms of the oil price. This is because it hasn't been increasing investment by as much as in previous cycles so the glut won't be as dramatic this cycle.
Areas of focus
“From an asset allocation perspective, we are therefore still focused on areas that benefit from better global growth such as the equity markets of Asia, Japan, the emerging markets – the commodity-related markets”, Wade said.
The emerging markets and commodity-related sectors in the corporate bond market should also benefit from a reflationary world.
Fixed income fund manager Michael Scott said: “We still have a positive view on the emerging markets given improved terms of trade as commodity prices have risen. Many have also seen an improved political environment with more market-friendly leaders now in place.”
Weak US dollar expected to persist
Another positive for the emerging world would be ongoing weakness in the US dollar. Wade expects the currency to maintain its depreciating trend.
“The dollar appreciated too aggressively after the Federal Reserve began talking about normalising monetary policy and is now in a period of unwinding. A strong dollar is never good for emerging markets. As other central banks around the world catch up with the Federal Reserve in normalising monetary policy, it could have further to fall.”
That said, central banks like the European Central Bank (ECB) and the Bank of Japan have adopted a “relatively glacial approach”, according to Scott.
“We think the ECB will probably end quantitative easing in September and that will be a big event for markets”, said Wade.
“Where we could be surprised is in the US. If wage inflation comes through quicker than expected the Federal Reserve could surprise on the upside and raise rates faster than anticipated”, Scott said.
In the UK meanwhile, Wade doesn’t see the economy as being strong enough to warrant rate rises from the Bank of England in 2018.
Opportunities in the credit market
Looking further ahead and turning to fixed income, Scott cautions corporate bond investors to be wary that although growth is buoyant at the moment, rising rates and the withdrawal of liquidity could precipitate a downturn in the credit cycle.
“We don’t think this is a 2018 story, but maybe from 2019 onwards, investors need to be cautious”, he said.
Scott is not overly concerned by the return of inflation and the prospect of rising rates, both of which are generally negative for bonds.
“Yields are well anchored at the long end of the yield curve. We think the Fed will hike at least three times this year and this will lead to a flattening of yield curves.”
On the threat of inflation, he said: “I don’t think bond yields are going to blow up unless we see aggressive inflation, which we don’t expect.”
On a sector basis within corporate bonds, Scott thinks opportunities are particularly rife in the oil and gas sector. “This is because they had their crisis in 2014-2015, after which they have restructured their business models to the lower oil price environment and the default rate is now coming down,” he said.
From a regional perspective, Scott finds reasonable valuations in the UK because people are nervous about relatively subdued growth prospects.
Also in the UK, Wade’s outlook has become more optimistic.
“As we go into 2018 we should see better inflation coming through in the UK. This means less of a squeeze on real incomes. The good side of sterling depreciation is feeding through into exports while the bad side is fading.”
Risks to reflation
The biggest threat to this reflationary world, in Wade’s view, would be a rise in protectionism from the US. “This could hinder global trade and remove an important engine of global growth”, he said.
Both panellists pointed out that Donald Trump was partly elected on the basis that he would resolve what the US administration sees as unfair Chinese trade policies, so there could be some action on this front this year given the mid-term elections scheduled for later in 2018.
In other US political developments, both panellists touched briefly on the US tax reform.
Scott said: "While the changes are beneficial to some onshore companies, those offshore that are effectively being encouraged to repatriate profits may well land up distributing these profits as dividends or share buybacks, which could be detrimental from a corporate bond perspective.”