By Krishna Memani
Irrespective of your political leanings, you have to admit that the last few weeks have been quite interesting, to say the least. Maybe “interesting” is the wrong word. Be that as it may, fortunately for investors, none of the fireworks in the political arena have really seeped into the overall tone of the financial markets.
On a global basis, the financial markets are still all about the synchronized global recovery that started in the second half of last year and continues to be strong, if not gathering further momentum. Growth outlooks are being revised higher and reported inflation numbers are edging higher as well. On the back of this economic strength and cyclical momentum, equity markets are reaching new highs. Expectations about improved earnings and corporate tax reform are all the rage. Furthermore, talk of reflation is not just talk; it’s getting embedded in market prices.
But, here’s the thing: The bond market is having some difficulty latching on to the reflation trade in a meaningful way. 10-year Treasury rates are meaningfully higher than their lows, for sure, but are having a great deal of difficulty breaking out (Exhibit 1).
Five-year, five-year forward breakeven rates are also up, but off their highs (Exhibit 2).
Further, U.S. Federal Reserve Chairwoman Janet Yellen basically threw in the kitchen sink for hawkishness—with talk of tightening, balance-sheet moves, etc.—and the U.S. had a very strong inflation number. Yet the 10-year barely broke through 2.5 percent.
In other words, the U.S. bond markets are watching and waiting, but far from convinced that the regime has changed. Equity prices, on the other hand, have already assumed that the regime has indeed changed. There is a bit of a disconnect there.
None of this is to imply that the Fed isn’t tightening. That train has certainly left the station and, on the basis of Yellen’s testimony, two rounds of tightening may occur this year: June and December seem like a given. But, the point of all of this is that two tightening rounds would not be a regime change for interest rates and inflation, in our view. They would simply reflect the synchronized cyclical momentum in the global economy.
As I have mentioned before, for the interest rate and inflationary regime to change on a global basis, savings in East Asia have to go down meaningfully. And, those savings don’t appear to be changing anytime soon.
In a world of free-floating capital, inflation is a global phenomenon. As a result, for the interest rate and inflation regime to change in the U.S. over the medium to longer term, despite extra savings being generated in East Asia, the policy prescription has to be radically stronger than the status quo—and it has to result in better productivity, meaningfully higher investment spending and a fiscal expansion.
The Trump administration, and the current Republican-controlled Congress, have promised just that.
Yet, there’s a challenge: The probability of radical policy prescriptions and fiscal expansion is high, but from what I can gather from the vacillations coming out of Congress, the trend is lower rather than higher. To some extent, the bond markets are incorporating a bit of that skepticism about policy prescriptions and their net impact on the outlook for regime change. Equity markets, on the other hand, continue to incorporate a significantly higher probability of radical policy prescriptions happening and soon. There is a clear market divergence that needs to be resolved.
So, there’s nothing significant investors can do right now. Still, it would seem to me that if one had an extended position or had gains to protect, reducing downside risk somewhat would be prudent at this juncture.
Krishna Memani is Chief Investment Officer, Portfolio Manager at OppenheimerFunds.
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