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Financial Expertise

Reflation – better late than dead

Financial Expertise

Reflation – better late than dead

Are growth and inflation rates declining again? This summer the odds of reflation happening were lower in financial markets. While we agree on the disappointing outcome of US stimulus efforts in particular, we are not writing off reflation yet. But it is indeed taking more time to feed through.

High-flying hopes…
Less than a year ago, global investors were shocked to see Donald Trump win the US presidential election. Judging from the immediate price reaction, the market’s verdict was clear: ‘This will stimulate growth and eventually generate inflation.’ Another chapter in the reflation saga post the Great Financial Crisis would be written. Accordingly, financial aggregates that are sensitive to changes in the growth/inflation mix jumped. Bond yields surged and commodity prices extended their 2016 comeback.

… given a cold shower
With hindsight, it has become clear that some asset prices got quite ahead of themselves last winter. This was particularly because the new US administration was not really able to exploit what political observers call the ‘honeymoon phase’ – i.e. the first few weeks in office, when newly elected presidents enjoy extra leeway to pursue their agenda. At the same time – and with far fewer media headlines – China removed some of the major stimulus it implemented in 2016, after saving the day for commodity markets. So with no initiatives out of Washington D. C. and dwindling support from Beijing, investors who had positioned themselves for further acceleration in growth and inflation rates have been in limbo year­to­date.

Growth has delivered – inflation is missing
Wait a minute: looking at growth expectations, economists have upgraded their growth outlook for most regions in 2017. So on the growth front, the world economy has delivered this year. And it has done so not with governments’ help, but rather through pent­ up demand materialising, particularly for commodities. Hence, the real disappointment lies in inflation, where the emphasis was placed on long­lasting pricing pressure in the post­crisis world. Here the projections went down all the way, except for Europe. ‘Why are prices in a thriving global economy so sticky?’ – economists asked themselves. After checking their good old textbooks, the debate about the Phillips curve arose once again. The Phillips curve is an economic concept developed by A. W. Phillips showing that inflation and unemployment have a stable and inverse relationship. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

Just late – not dead
The debate raged in economists’ circles beyond the summer. Many of my fellow strategists declared the Phillips curve concept dead and useless. We beg to differ: although rejected by many, the pattern of scarce labour kick­starting price increases in an economy cannot be easily dismissed when looking at the numbers (see chart). If we take the rate of underemployment as a proxy for available labour, we can easily see that after falling below a level of about 8%, wage inflation took off historically. That is where we are in autumn 2017. So we would rather wait and see whether things really are different this time before calling it a day for reflation in this cycle.

Give it until year end
Given the uncertainty, we prefer to give the reflation trade the benefit of the doubt, at least until the end of the year. By then we should be better able to assess whether things really are different this time. On a different note, there is not only inflation but also hyperinflation – in cryptocurrencies, for example. In our view, bitcoin is a replay of previous bubbles.

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