Jefferies

Economics and Strategy

A Cyclical Reflation

— Sean Darby, Global Head of Equity Strategy

Pushing worries over French and Dutch elections aside, global equities benefited from ongoing inventory restocking, higher producer prices and a broadening recovery in emerging markets. The fact that all major stock exchanges have shown at least single digit gains is testament to a broad reflation of the global economy. For the first time since mid-2011, global earnings revisions (upward minus downward) have inflected positively. At least for equity investors, analysts and company CEOs are now feeling confident enough to raise earnings estimates over the past month. In this regard, the risk that reality might not match sentiment indicators is beginning to fade.

A glance at fund flows since the Trump election suggest that while there has been no great jump from one asset class to another or for the much hope for bond to equity switch, there is a much more subtle shift occurring. In equities, the U.S. has certainly seen solid inflows but the breadth of equity buying has widened with Europe experiencing solid cash injections as well as Japan.

Investors argue that the ‘reflation’ trade is solely due to a rebound in energy prices. This is not true, in our view. The price increases have been broad based from silicon wafers to paper, from steel to copper, and have reflected both bottlenecks, capacity constraints and an underestimation of demand. It has been international. Equally, the Producer Price Index numbers are turning better in Europe and also in Japan, while export data has firmed in Germany and Korea.

In contrast to the past five years in which bond proxies or ‘reach for yield’ stocks outperformed, a more traditional cyclical rally is evolving with steel, chemical, mining and energy stocks rallying accompanied by financials.

The bottom line is that we believe global equities are in a sweet spot with rising asset turnover and pricing power helping the shares of the real economy while higher bond yields and firming input costs will weigh heavily on the ‘bond proxies’ in 2017.