Reflation Nation: “Righting” The Wrongs With A Single, Enduring Populist Push

Do you believe in miracles? Apparently somebody does, which is why we’re seeing record after record on Wall Street in the wake of Donald Trump’s surprise ascent to the highest office in the land – a confirmation of the populist surge that propelled the Brexit vote, led to the downfall of Matteo Renzi in Italy, and most recently led to the impeachment of South Korea’s Park Geun-hye.

Personally, I’m not impressed. For every one member of the electorate who has thought this through and truly knows what they’re voting for, there’s (at least) one voter who has absolutely no idea what they’re supporting and is simply following the movement out of some misplaced loyalty to an ideology that purports to “right” (no pun intended) the world’s wrongs by dislodging “corrupt” politicians and replacing them with outspoken ideologues who I think voters will find are rather difficult to get rid of once their utility has run its course.

This is just fine with the non-Western world of course because it replaces experienced statesmen and women with gallivanting loudmouths that are quite frankly easy to manipulate even as they claim to be their repspective countries’ saviors in a world heretofore dominated by pork barrel politics and log rolling by corrupt politicians and entrenched business interests.

Western electorates will figure this out in time but apparently we’re going to try it first which is a shame because it plays right on into the hands of non-Western interests and all in the name of making this or that “great again.” We’ll see how much “greater” the US is five years from now. The same goes for Britain and an EU that, thanks to a profound disillusionment with the notion that the bloc should serve as a safe haven for those fleeing the war-torn Mid-East, is slipping deeper and deeper into a nationalistic, populist fog that in some cases (not all) manifests itself in openly racist dialogue and public displays of xenophobia.

Anyway, for the time being the Trump effect has been to ignite a reflation trade that many had left for dead. Here’s a decent summary of where we were from FT:

A year ago, there was a pervasive mood of gloom among economists and investors about prospects for the global economy in 2016.

Since then, however, there has been a marked rebound in global activity, and in recent weeks this has become surprisingly strong, at least by the modest standards seen hitherto in the post-shock economic recovery. According to the latest nowcasts, the growth rate in global activity is now estimated to be 4.4 per cent, compared to a low point of 2.2 per cent reached in March.

Whatever, right? Well this line is becoming increasingly popular among analysts. Just ask Goldman’s Joshua Schiffrin, the firm’s first dedicated TIPS market maker and a senior trader in the bank’s US Government Bond Trading and US Inflation Trading units. Here are some excerpts from a recent interview:

The election of Donald Trump caught so many clients by surprise that they are now scrambling to figure out what the new world landscape will be under his administration. Everybody is going back to the drawing board and questioning their old assumptions. The key question is whether the sharp move in the Treasury and inflation markets is a short-term shift that is nearing its end and will soon stabilize, or the start of a bigger secular shift that’s going to play out over the next five-to-ten years.

Taking a step back, this does not look like the final stages of a move, but rather the beginning of something that is going to play out over a much longer timeframe in markets. I think this is one of these moments in the market that comes around very infrequently, marked by a big rethink about policy approaches. Even before the election, central banks were rethinking the wisdom of depressing term premium in the bond market to ever-lower levels in the hopes of spurring aggregate demand, and increasingly acknowledging the negative effects of flat yield curves on the banking system. In the US in particular, the degrees of freedom for how Fed policy may operate could be quite large, as it now seems likely that there will be a new Fed chair in early 2018. At the same time, administrations around the world are increasingly considering whether they should be doing more from a fiscal perspective. Japan is in the process of enacting a fiscal package. The UK has eased back on austerity. And while we are waiting for details from the new US administration, it seems pretty clear that there will be an about-face with respect to tax policy, spending policy, and regulation. So policymakers are shifting gears dramatically from a world in which monetary policy was bearing the sole burden of stimulating the economy to one in which fiscal policy will be playing a greater role. That dramatic shift, combined with rising anti-globalization or protectionist sentiment and OPEC’s move to defend the oil price, has very quickly shifted the fat tail of the distribution from the low-growth/disinflation end to the highgrowth/inflation end.

Goldman’s Jan Hatzius also weighed in on the issue, noting that the trade was already on before Trump’s victory:

The basic story that core inflation would move much closer to the Fed’s target was already on track prior to the election. The combination of a tighter labor market, rising healthcare costs, and fading passthrough from commodity and currency effects were all pointing to higher inflation. In fact, the core numbers had been coming in just a touch higher than we thought they would; we are now forecasting core PCE inflation to reach 1.8% by year-end vs. the 1.6% we had expected heading into 2016. The election outcome has reinforced our view. We are currently assuming that Congress will pass a fiscal package worth 1.0% of GDP. That would likely lead to higher inflation alongside higher growth, especially given that we are basically at full employment. However, there are some risks to our base case from the political opposition to deficit-financed fiscal stimulus.

And in any case, we would not expect major changes to fiscal policy before the middle of next year. Trump’s stance on trade could also pose upside inflation risk since he will probably face considerable pressure to deliver on some of his protectionist campaign proposals. Tariffs are one area where he could take action; we estimate a 10% increase in US tariffs on average would add 0.6pp to the level of core PCE. That’s not enormous, but at relatively low levels of inflation, it makes a difference.

(click to enlarge)

Further tightening in the labor market should continue to support wage growth; much of this will likely show up in weaker profit margins, but some of it will show up in price inflation. Healthcare inflation is also likely to continue to increase, especially in the PCE index where healthcare cost increases have lagged relative to the CPI. And the pass-through from declining commodity prices and a stronger dollar is likely to further diminish; these lagged effects are probably still taking ¼pp or so off of core PCE, but their impact should continue to unwind.

See, we were already headed in the “right” direction – all we needed to do was elect a populist who likes to talk about fiscal stimulus and trade wars to push us over the edge.

So I guess the question is obviously this: what happens if inflation expectations continue to rise but the outlook for growth remains muted. I mean if we’re being realistic that kind of seems like the most likely path, right? Well, then you get stagflation and suddenly America won’t be getting “great again.”

Here’s Goldman’s Joshua Schiffrin again:

That will depend on the actual policy mix under the new administration, which remains unclear. A big infrastructure spending plan and a large tax cut would likely be positive for both growth and inflation over a longer term. But if the policy mix is more focused on protectionist measures, that might mean higher growth in the near term but slower growth in the long run-as well as persistently higher inflation- because it would suggest lower productivity growth. To me, it seems clear that the new administration has a strong intent to push up nominal growth, but whether that comes through higher inflation or higher real growth is to be determined.

And here’s a bit more from Hatzius:

Given that we are practically at full employment but still below the inflation target, having higher inflation and lower growth compared to today’s levels is almost inevitable.

But if we see further progress in the labor market and moderate gains in inflation-of ¼pp or so-I think we would be better off. The fact that our growth outlook is better for next year than what we’ve seen for much of 2015-2016 helps that. In any case, I think we are extremely far from any more concerning scenario akin to the stagflation of the 1970s driven by sharp spikes in oil prices.

Ok then. So what does all of this mean for equities (SPY) which, as a reminder, are trading at historically high multiples that really can’t do anything but contract from here? Well, let’s ask Goldman’s David Kostin and Peter Oppenheimer:

Oppenheimer: A bit of inflation resulting from stronger growth is obviously a positive for equities, but there is a limit. As I mentioned, low bond yields have pushed equity valuations to relatively high levels, so a continued rise in bond yields on inflationary momentum would very likely weigh on valuations. On our estimates, the tipping point may be when 10-year US Treasury yields surpass 2.75% or 10-year German Bund yields get to 0.75-1.00%; at that point, any further rises in bond yields would probably be negative for stock returns.

Kostin: Higher US inflation and Treasury yields will weigh on valuation expansion in the second half of next year. The average S&P 500 forward P/E multiple when 10-year Treasuries are yielding 2-3% has historically been 14.2x-but we’re currently starting from a forward P/E that is stretched by historical standards according to almost any metric. I believe the five-year P/E expansion cycle has come to an end. The multiple has increased by 70% since the low in 2011, well above the typical expansion cycle of 50%. The S&P 500 will trade at 2300 in 12 months, after rising to 2400 in the early part of next year, but the appreciation will reflect higher earnings rather than a higher P/E. In a more inflationary scenario than our economists currently envision, that adjustment might happen more disruptively.

So in other words, there are any number of reasons to believe that both stocks and bonds decline from here, an eventuality that bodes particularly poorly for risk parity funds which you’ll recall bit the dust hard in the aftermath of the August 2015 selloff.

But the larger point is that the reflation trade needs to be underpinned by expectations for stronger growth – otherwise we’ve just got stagflation as tariffs drag prices higher but real growth remains stuck in neutral.

If this were as simple as enacting a fiscal spending package and slapping an import tax on China and Mexico, someone would have already done it. Managing an economy and, more pointedly, a modern state is more complicated than many populist candidates and their supporters imagine.

They’ll find that out in time – the only question is how many things they irreparably screw up in the interim.