Peak Reflation May Be Looming
The reflation trade appears intact, but U.S. stock gains could slow if the economy reaches a momentum peak.
by Jurrien Timmer, Director of Global Macro, @TimmerFidelity, Fidelity Investments
Key Takeaways
• The Fed’s dovish hike averted a mini taper tantrum and gave new life to the reflation trade—investor optimism that Trump’s policies will eventually prove effective in lifting U.S. inflation and growth.
• Nevertheless, the U.S. economy may be approaching a momentum peak, which could also mean a reflation peak, and lead to a slowdown of the U.S. equity rally.
• A cyclical (economic) momentum peak generally signals an end to the above-average-return phase of a stock rally; stocks often continue to advance following the peak, but at a more muted pace.
• Coupled with a weaker U.S. dollar and lower Treasury yields following the dovish Fed hike, a potential reflation peak implies a continued convergence among global equities.
In recent weeks, a new mini taper tantrum appeared to be under way—yields rose, driven by a sudden jump in the number of Federal Reserve (Fed) rate hikes priced into the markets over the next two years. But the Fed’s “dovish hike” reversed that scenario. What prompted the mini taper tantrum? The Fed, of course. With New York Fed President William Dudley’s successful trial balloon of a March hike a few weeks ago, the number of expected hikes priced into the market over the next 24 months jumped from 3.6 to 5.0, and the March hike was 100% priced in.1
A dovish surprise
Although the Fed indeed hiked its baseline rate by 25 basis points at its March 15–16 meeting, it surprised the markets with a so-called dovish hike—meaning that it left the “dots” as is. The dot plot represents the Fed’s forward guidance by showing individual policymakers’ forecasts for the fed funds rate over the next several years. Prior to the March meeting, the consensus was that the Fed would raise its dots to suggest three or four hikes in 2017. But that didn’t happen.
And just like that, real yields fell again, as did the U.S. dollar and the number of hikes priced in according to the fed funds forward curve. Contrary to the markets’ fears, the median dots for 2017 and 2018 stayed right where they were in December. So, as quickly as Dudley’s earlier comments caused an upward re-rating of the Fed’s tightening path, we are back down to the status quo of two or three hikes in 2017. With its dovish March hike, it appears the Fed simply took
advantage of the opportunity to get a hike in now while the markets’ animal spirits2 would allow it. With that out of the way, the 10-year Treasury yield came back down following a retest of its December 2016 high of 2.64%.3
More importantly, the broad U.S. dollar is trending lower again, falling from $102 to $99 over a three-week span in March, according to the U.S. Dollar Index. Also helping the dollar move lower was a euro-favorable outcome to the Dutch election. The French election is still to come, but this was a step in the right direction, eliminating a potential source of risk for the European economy.
Emerging-markets equities have now fully recovered from their brief correction, and the Commodity Research Bureau’s Raw Industrials Index (a good proxy for global growth) is again reaching new cycle highs. The latter has supported my thesis that we have been in a synchronized global upturn for the past year. The index never wavered during the corrective market action of the past few weeks, holding on to its gains while other commodities corrected lower. More on the global convergence theme, later.
Cyclical momentum and U.S. stocks
The reflation trade in the U.S. appears to have regained its footing, meaning investors seem to have renewed optimism that Trump’s policies will be able to lift U.S. inflation and growth. And with the Fed out of the way for now, we can resume monitoring economic data to get a sense of when the market may reach some sort of reflation peak. A key piece to that puzzle will be to gauge the momentum of high-frequency economic indicators, such as purchas.ing managers’ indexes (PMIs). When they reach peak momentum, it will suggest peak reflation, begging the question: What could this mean for U.S. stocks?
I ran a simple analysis to see what tended to happen to the stock market when PMIs (indicators of economic growth) reached their initial peak (Exhibit 1). The Institute for Supply Management (ISM) PMI diffusion index reaches an expansionary peak (usually around 60) after recovering from levels indicating economic contraction (below 50). My goal is not to pinpoint a turn in the overall cycle, but to understand what happened to stocks when the economy reached peak momentum.
Importantly, a momentum peak for the economy doesn’t always indicate a peak in the economic cycle. Far from it. Remember, momentum measures the rate of change, not the direction (growth or contraction). In some cases, the momentum peak was indeed the absolute peak for that cycle (e.g., 1961, 1972, 1987, and 1999). But in many other cases, the economy continued to grow long after the momentum peak, just at a generally slower pace. As shown in the chart, there have been a broad range of cyclical outcomes following momentum peaks.
I found that when the ISM index is rising toward a reflation peak, the stock market has tended to post above-average gains. Then when the peak occurs, the market often corrects for a few months, but it’s usually not the start of a bear market. Of course, there are exceptions: notably, the 1987 crash, the bear market in 1973–74, and the post-bubble decline in 2000–02. But more often than not, the market tends to lose momentum for a short time before rising again.
In other words, a reflation peak generally does not mean a peak in the stock market. But it does mean a loss of momentum. Importantly, Exhibit 1 shows that the market has historically risen faster than its long-term trend-line of 10% per year heading into a momentum peak, but more slowly following the peak. (To the left of the peak, the mean is converging toward the trend-line, while after the peak the mean is diverging from it.)
When PMIs and other such economic indicators are still gaining momentum (as they have been since bottoming a year ago), a rising stock market is a likely scenario. But once the ISM index reaches its peak (high 50s or better), more actively inclined investors may want to monitor the level of risk in their portfolios more carefully.
The ISM index is currently at 57, suggesting the U.S. economy may be nearing a momentum peak (if we aren’t already there).
The track of the ISM index since a year ago matches the historical average track pretty closely. This suggests that the U.S. stock market may be in the final innings of its above-trend rally phase, and that moving forward, the market will likely advance, but with less momentum.
Global implications
This takes us back to the theme of global convergence. With the Fed on a steady path that is fully priced in for now, and with the European Central Bank beginning to guide us toward a less accommodative path ahead, the U.S. dollar should be moving lower rather than higher. This is especially true if investors perceive that the Trump fiscal agenda may be losing momentum. If the tax reform with border-adjustment tax agenda fails to happen this year, or if it is replaced with tax relief without spending handcuffs (think Bush-era tax cuts), then the “Trump trade” could quickly go from a strong-dollar story to a weak-dollar story, leaving the consensus once again wrong-footed.
Since the 2009 stock-market bottom, international and emerging-market equities have lagged the S&P 500 by 150 percentage points. Since 2011, these markets have gone nowhere while U.S. stocks have posted significant gains. Now, though, non-U.S. earnings are inflecting higher but from deeper bottoms and against much cheaper multiples.
This spells mean-reversion, if you ask me, and could signal opportunities for investors in equity markets abroad.
Author
Jurrien Timmer, Director of Global Macro, Fidelity Global
Asset Allocation Division Jurrien Timmer is the director of Global Macro for the Global Asset Allocation Division of Fidelity Investments, specializing in global macro strategy and tactical asset allocation. He joined Fidelity in 1995 as a technical research analyst. Fidelity Thought Leadership Director Christie Myers provided editorial direction for this article.
For Canadian investors
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Endnotes
1 Federal Reserve Board, Bloomberg Finance L.P., as of Mar. 1, 2017.
2 A term used to describe human emotion that drives business and consumer confidence.
3 Bloomberg Finance L.P.
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