May 5, 2017

This week’s ‘Insights’ touches on the expectation that the current ‘reflation’ cycle is going to lose steam, driven by a soon to be much slower China. We are already witnessing a number of inflation indicators rolling over and, with the ‘tightening’ of China’s money supply, this likely has further to go.

The massive government led infusion of credit and money in 2016 reversed the expectation many had, this analyst included, that China was likely to export its deflation to the rest of the global economy. This infusion is now reversing.

Source: BCA Research

Commodity prices are also starting to roll over, on the back of anticipated weaker growth as China’s money supply slows.

Source: BCA Research

What does this all mean?

Emerging markets that have trading ties with China are likely to sell off. Markets such as Taiwan and South Korea have had a tremendous rally on the back of China’s monetary stimulus but as this reverses, so will the trade. EM corporate bonds are also looking relatively expensive, with spreads close to 10 year lows.

Source: BCA Research

Global and US inflation may slow:

A slower China will tilt global inflation expectations lower. As the world’s second largest economy, a slower China will drive commodity and export prices lower as well as demand for imports, which will directly impact the emerging markets. A big driver of inflation in the US was the increase in crude prices, but this has subsequently also reversed.

Source: Trading Economics

Trump’s policies may be inflationary further out, but in the short/medium term China’s money flows are likely to have a greater impact on global inflation expectations.

Yields on the US 10yr Government bond, having troughed in early 2016 at 1.4%, rose dramatically on the ‘reflation trade’ to 2.6%, with speculative short positions reaching record levels on long duration government bonds. As inflation indicators start to slow, however, longer duration bonds should be well supported. Certainly, a slower China will counteract some of the expected wage pressure inflation in the US.

In our view, a barbell approach, having exposure to short duration assets such as MBS, with a long duration US government bond trade on the other side seems prudent. A contrarian trade perhaps, but looking at the data there seems little pressure for yields to go much higher at the moment.

Precious metals will come under pressure:

We have already seen gold and silver sell off as the reflation trade wanes, with silver already down some 10% over the last month alone. In the very short term it may be a little over sold, but if right on inflation expectations falling, there is likely to be further downside.

Gold and silver are still the ultimate hedge for a loss of confidence in the central banks and fiat currency, so adding marginally on these dips seems a prudent policy to be prepared for this eventuality.

Conclusion:

Not an easy environment to invest in, one which is still very much driven by central bank and government action.

We still believe the best course of action is prudence over valour and taking a multi-asset approach makes a lot of sense. Reasonable income generation with idiosyncratic uncorrelated alpha is the name of the game, aiming for reasonable returns with controlled downside risk.