Reflation Trade Becomes Consensus…

In a vintage year for contrarian asset allocation, the trajectory for markets has been to overreact to China deflation/devaluation risks, the shock of the misguided negative rates experiment (which served to confirm deflation fears and therefore backfired as a signalling tool) and what we termed the  ‘sideshow’ of Brexit. Overly pessimistic expectations were reset from Q2 as macro data such as PMIs and net earnings revisions across the MSCI AC index rebounded (led by EM), reflected in the turn in bond yields from July as ‘macro hypochondria’ peaked.

Positioning for the commodity cycle and EM bottoming in Q1 looked to us like a compelling bet, as did overweighting value as a style factor. Globally, value has outperformed by about 20 ppts since July, the second-best run versus ‘quality’ as a portfolio factor in almost 40 years. Our rotation from bond yield flattening to steepening sector exposure mid-year (including long Eurostoxx banks) also generated huge alpha in the tactical portfolio. If there was one issue this year which reflected a spectacular failure of nuanced analysis and caused global shock waves, it was the Q1 panic over Chinese FX reserves and the risk of a ‘shock devaluation’ which coincided with equally hysterical forecasts of oil going to $20 to generate a deflation panic rippling across markets.

Our view was that at least half the apparent capital flight was in fact rapid FX debt deleveraging and that rather than a deflationary shock, China was poised to inject an inflationary impetus to the global economy as the investment cycle turned. Ironically, the rebound in China’s fixed investment (particularly residential construction) has been weaker than we expected but the surge in industrial commodity prices even stronger, now that reflation is suddenly fashionable as an investment thesis. We stuck with a $50-60/bl end 2016 oil price target as market rebalancing began, making global E&P stocks and US HY energy debt a contrarian overweight. Meanwhile, the RMB correcting from very overvalued real effective levels was something to be welcomed, so long as orderly.

The US election has provided an alibi for sell side strategists to wipe the slate clean on an astonishing series of analytical errors and belatedly jump on the reflation trade. If the overwhelming investor consensus a year ago was for further EM/commodity downside and long quality/growth, this year it is long USD and reflation winners and positioning has shifted accordingly but simplistic extrapolation remains the default forecasting tool of most analysts. Indeed, almost comical herding behaviour continues to define markets from oil to the JPY (for instance, the yen has seen consensus targets versus the USD gyrate from 125 in mid-2015 to 90 by mid-2016 and now back to 125 again). Investors have been stampeding in and out of markets with record speed as the narrative and momentum shifts. With the rise in AUM of systematic trend following funds and the retail ETF hordes that ride their coattails, markets have never been more of an ‘echo chamber’ of confirmation bias  – remaining strictly agnostic is key to getting ahead of crucial inflection points.

The consensus was hugely misguided a year ago, and the impact of the Trump regime whether in terms of tax policy or geopolitics looks less benign than it now naively expects. Ultimately, if Trump is to attract cheers rather than jeers at the rallies he intends to continue holding for his rustbelt true believers, low-skilled labour has got to get a bigger share of the economic pie i.e. companies will have to divert cash flow from shareholder distributions to capex and wages and shift their capital structure from debt to equity.

Tax cuts will accordingly come with strings attached designed to incentivise investment and manufacturing re-shoring. The USD and Treasury yields are not a one-way bet given subtle negative feedback loops and both look extended, global miners ex gold now look relatively expensive and quality growth/defensives decent value again. While 2017 is unlikely to be quite the contrarian bonanza this year was, it would be wise to read those investment bank annual outlook notes with a healthy degree of scepticism. Or perhaps safer still to ignore them completely…