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Ready for Reflation

Author: Andrew Sheets
Ready for Reflation

Morgan Stanley & Co.’s (MS & Co.) economists see global growth broadening, with reacceleration in the US, upward revisions to Euro Zone forecasts and an intact Japanese recovery. They see inflation for the G3 economies bottoming imminently and then picking up, as growth improves and unusually large distortions from oil prices roll out of the year-over year comparison. MS & Co.’s forecast for global inflation has slightly increased since the 2015 outlook was first published, to 3.1% from 3.0%; the 2016 CPI forecasts are materially above consensus in the Euro Zone and Japan (see table). Together, these trends support a shift in market focus toward inflation and away from deflation as the year progresses.

Broader growth and better inflation present a constructive backdrop, although one that’s not without risks. With the new growth and inflation profile, it also appears that the Federal Reserve’s rate hike will be earlier, in December 2015, rather than in March 2016. Asset valuations are not cheap. Emerging market economies still need to adjust and corporate America is getting more aggressive. Liquidity in many corners of the market is dreadful.

For now, however, we see these risks as manageable and see both risk premiums and our economic story supporting a “reflationary” theme. We remain overweight equities versus bonds, believe higher inflation and low term premiums will lead to steeper yield curves and expect spreads to tighten. Many of our micro themes, from being overweight financial and energy stocks globally to expecting some of the best risk-adjusted credit returns in floating rate assets, also grow out of this view.

Let’s start with better growth, which admittedly has long seemed just over the horizon. Our expectation of a stronger second half has several drivers. US growth, which stumbled in the first quarter due to a strong dollar and heavy energy disinvestment, should improve as these headwinds moderate. Euro Zone growth is tracking better than our previous forecasts, with a weaker euro and improving loan growth still working through the system. Japan is on track for its strongest nominal growth since 1991, and China’s recent easing measures in the local housing market could help to support consumer demand in the second half.

As growth recovers, so should inflation. Part of this is simple math. Energy accounts for some 11% of headline inflation in Europe and 7.5% in the US and, by late autumn, it should no longer be falling substantially on a year-on-year basis. A big negative number falling out of an average helps to raise what’s left. In our view, G3 government bond yields, breakeven inflation and Fed funds futures currently price in little inflation premium. The financial media was happy to trumpet the deflation narrative in the first quarter despite much of it being oil related. We suspect the story will reverse as headline inflation starts to move higher. What’s more, the rise isn’t all about oil.

In Europe, wage settlements and capacity utilization are rising, while services inflation has begun to tick higher. US wages should be rising at a faster pace by September. Wage growth in Japan is running at its strongest levels since 1998, and should continue to climb (on our forecasts) as the labor market tightens further. Markets excel at extrapolation, and this sounds like a good enough excuse.

A Change to Our Fed Call

Having long assumed that the Fed would wait until 2016 to raise rates, we now expect the first hike in December. This is roughly in line with market pricing and puts the start of the hiking cycle firmly in this calendar year. Once the Fed starts, we expect an alternating series of hikesand reductions in mortgage-backed securities holdings at each meeting, for a total of 150 basis points of hikes between now and year-end 2016.

Are markets prepared? We think the answer varies. US investment grade, high yield and emerging market credit have given up all spread tightening since late 2013. Currency volatility is back above its long-run average. US stocks have gone nowhere in four months. Moreover, the history of previous hiking cycles is anything but conclusive. US credit rallied into the 1994 hike and sold off after, but did the opposite in 2004. Looking at three Fed hiking cycles since 1986, credit, equity and Treasury total returns before and after the hike are mixed (see table). On average, however, returns before the first rate hike have been positive more often than negative.

Hiking cycles are hardly harbingers of doom, and it is notable that MS & Co.’s interest rate strategists see the US having one of the best-behaving rate markets through year end. Conversely, we see emerging markets as more exposed versus prior cycles, which is one reason we remain cautious on their currencies and stocks.

A Cycle Intact

We continue to expect that this cycle will be a long one—perhaps the longest global expansion in recent memory. It should be unusually long because it has been unusually weak, followed an unusually severe downturn, and is unusually unsynchronized on a global basis. More tangibly, we do not think it yet possesses the level of optimism or hubris we’d associate with “late cycle” behavior, which is a message we see borne out in our cycle indicators. The disjointed nature of the current cycle makes it easy to find indicators that make conditions look particularly good (or bad), depending on one’s point of view. We think the most fair and least emotional approach is to focus on a broad array of measures. Our cycle indicators are designed for this, and neither the cycle nor the broader measure that incorporates Europe and Japan is at extremes (see chart).

Yes, US mergers-and-acquisitions volume is near previous-cycle highs, but other measures, from US consumer confidence to corporate loan growth, are far more normal. Global activity, meanwhile, is still well short of the intensity that made the downturns of 2000 and 2008 so severe. All contribute to our view that the global expansion has further to go.

Valuation: How Extreme?

Levels of activity may not be extreme, but what about valuations? Asset prices are routinely described as being “manipulated” and “inflated” by central bank policy and, although these charges have been leveled for several years, they need to be addressed. Specifically, how far has recent central-bank policy pushed valuations from their 20-year averages? Look at the past 20 years, and most are in the middle of the range. Price/earnings and price/book ratios for the MSCI All Country World Index (MSCI ACWI) are below their 20-year medians, while the same measures for the S&P 500 have been richer about 40% of the time over the same period. Credit spreads in US investment grade and high yield credit are pretty average over this range. Government bond valuations, in contrast, look highly distorted by central bank policy, which is one reason we are underweight.

We continue to believe that the market could “melt up”—that is, trade to richer, more ill-advised valuation—before it “melts down.” The upside left in our cycle indicators is one reason for this, as is the gap between US nominal growth and bond yields, a measure frequently cited by our currency strategists. When long-term rates are below nominal GDP, growth-sensitive assets are attractive relative to their financing costs, and asset booms are common. We saw that in the 1997-to-1999 and 2003-to-2007 periods, which ended at valuations higher than those of today.

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