Jefferies

Economics and Strategy

Reflation to Dominate Global Equities in 2017

— Sean Darby, Global Head of Equity Strategy

Reflation will be the dominant theme for global equity markets in 2017. With Trump’s policies set to mean higher growth and inflation in the U.S., as well as China exporting inflation for the first time in four years, global equities will take their direction from the steepening of yield curves. This should mean that low PE and PB stocks will do well. This is good news for active investors. The main risk for equities is if the dollar strengthens too fast and U.S. rates were to rise too quickly.

A regime shift occurred almost overnight following Trump’s victory. Trumponomics: fiscal relaxation and protectionism are both inflationary and USD bullish. The unfolding of Trump’s policies will occur at a time when wages are increasing – buy the U.S. consumer. The shift in temperature for the U.S. economy from monetary stimulus to fiscal has finally changed perceptions over inflation. This ought to mean that the flow of money emanating from fixed income will seek stocks with pricing power.

Despite better economic growth in 2016 and an improvement in headline inflation, investor sentiment remains depressed towards European bourses. A front-loaded election cycle in 2017 has once again raised question marks over the viability of the euro system. However, it would seem a lot of the bad news is in share prices with many stocks trading below 1.25 times book. Europe is cheap, the corporate sector in most cases is running free cash-flow while investor sentiment is bearish. A change in the inflation temperature might be the first catalyst to reignite investor appetite.

In September, the Bank of Japan (BoJ) pledged to target a zero yield on 10-year Japanese Government Bonds until deflation is finally beaten. The BoJ Governor promised to keep increasing the monetary base until inflation is above 2%. In essence, the BoJ is committed to keeping nominal yields pegged near zero and allowing inflation to rise. The equity market remains attractive: 30% of the stocks are trading below book value while the running yield spread (dividend plus buyback yield minus treasury yield) is still around 2%.

Asia is set for another character test as the U.S. moves its policy setting from monetary to fiscal in 2016. The Association of Southeast Asian Nations (ASEAN) has left its rates too low versus the U.S. and will probably need to tighten rates to defend their exchange rates. In contrast, China has accepted an inflationary route and will allow the renminbi (RMB) to weaken. North Asia sits in the ‘middle ground’ with a soft cushion to external threats but directly competing with China’s export machine.

Jefferies sees three themes to watch. Firstly, the likely collapse of the Trans-Pacific Partnership will help China to engage in bilateral trade deals and extend its influence through ASEAN. In turn, this will allow for a wider introduction of the RMB. Secondly, Asian central banks will need to live with a stronger dollar and this may mean tightening policy earlier than anticipated. Lastly, Korea and Taiwan will need to manage a path between their declining prowess in global trade and the fact that China is stretching its political and economic power ever closer to their countries.