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Worldwide, the trades dependent on the reflation investment theme – an acceleration in U.S. economic growth and rising inflation expectations – are coming undone.
The reflation trade became known as the Trump Trade after the U.S. election, but, in truth, it was well underway before November. Cyclical stocks, those that benefit most from rising economic activity, began outperforming in the summer of 2016 as institutional investors positioned themselves for a more optimistic growth outlook.
The first chart below compares the relative performance of the FTSE All World Cyclicals Index and FTSE All World Defensives Index (I simply divided the value of the cyclicals index by the value of the defensives index). A rising line indicates the outperformance of economically sensitive sectors which include resources, industrials and consumer discretionary stocks.
Cyclical sectors began outperforming defensive stocks at the end of June 2016 and this market theme persisted until the end of January 2017. After that point, defensive stocks resumed their outperformance of economically-sensitive sectors, indicating declining market faith in global growth.
The most obvious place to gauge inflation expectations is the U.S. bond market. The yield on longer term bonds rises (and bond prices fall) in accordance with the market's inflation and growth forecasts.
The second chart below illustrates recent trends in U.S. fixed income. The ten year bond yield shows a similar pattern to the first chart – climbing as economic optimism increased, then reversing course and heading lower as investors' economic skepticism took hold.
The chart also plots the steepness of the U.S. yield curve, the difference between 30-year and 5-year U.S. Treasury yields. Steepness is a key indicator – the yield curve steepens (and the line on the chart rises) as future growth expectations climb. An extremely steep yield curve would represent a market belief is strong economic growth for the long term.
The steepness of the yield curve is extremely important for banks and other lenders. The primary business of finance is to borrow money at short term interest rates and lend these funds to clients at longer term interest rates. The interest on the short term borrowing rate is their cost and the interest paid to them at longer term rates is their revenue. The difference between these two payment streams represents the bank profit on loans. So the steeper the yield curve, the most profit lenders make.
The U.S. yield curve has been flattening, not steepening since November of 2016, dimming the profit outlook for U.S. bank stocks. It is no surprise then that U.S. bank stocks were among the worst performers during Tuesday's sell-off. The KBW Bank Index fell a full four per cent for the session.
The market volatility in recent days is explicable viewed through the lens of falling growth expectations. The weakness in the oil and coppers prices, combined with falling bond yields, are all signs that global markets are readjusting portfolios for slower future economic expansion than previously believed.