The 'reflation trade' and four other trends that will shape 2017

February 16, 2017

The world seems a very different place as we start 2017, with 'reflation' the theme of the moment. While Trump's victory is widely cited as the key driver of change, closer inspection suggests that changes were already underway prior to the US election with global leading indicators recovering steadily through the second half of 2016.

Indeed, a number of key indicators suggest that the global economy has been healing for some time.

Though monetary policy has played an effective role in enabling the global economy to heal, it seems to have reached its limits, with diminishing returns to rate cuts and quantitative easing.

Fiscal easing was one of Trump's pledges, but whether other countries will follow suit remains to be seen. Nonetheless, the rising tide of populism suggests that one should expect a greater focus on fiscal policy globally.


In an environment of high unemployment and spare capacity, risk assets should generally continue to benefit from a policy of reflation. In the US, however, unemployment is now at low levels and spare capacity is limited.

Fiscal expansion there is unlikely to provide many more jobs but is likely to lead to higher inflation, imports and interest rates. How this plays out will be a key driver of investment returns over the course of 2017.

With planned tax cuts and higher spending amounting to around 2 per cent of GDP, Trump's proposed fiscal measures represent a significant move, given where the US currently stands economically.

Wage inflation poses a potential drag on profits but a US dollar that has risen by a third from its trough in late 2011 should serve to reduce inflationary pressure and, therefore, limit the extent of interest rate rises.

This should, in turn, ease some concerns over the immediate outlook for bond markets. Yields are likely to rise but the upside remains constrained by what will likely be relatively limited rises in short rates and modest nominal growth.

Trade is the other key area of Trump-driven change. The impact of effective export subsidies and protectionist measures could result in higher inflation in the first instance which may strengthen the dollar further.


Emerging markets will be heavily influenced by events in the US.

An environment of rising interest rates, bond yields and the US dollar does not typically bode well for the relative performance of emerging market assets, but this area does have the attraction of a value discount and improving growth relative to the broad developed world.

Russia and Brazil are exiting recession and there is scope for easing of domestic monetary policy in a number of areas.

Provided that yields rise only modestly and dollar strength is not pronounced, there are reasons to believe that emerging markets performance will turn more positive on a relative basis in 2017.

Trump once again, presents a risk to the benign scenario and his stance on China remains key in this regard.


The UK will be in focus with PM May's stated objective to trigger Article 50 by the end of March.

2016 saw surprisingly strong performance for the UK-based investor, but much of the return was a function of sterling weakness, which has already fallen to levels which suggest undervaluation from a longer-term perspective.

Whether this value is realised in 2017 will be a critical driver of UK equity performance, which remains heavily influenced by currency volatility.

A squeeze on real income is expected through the year with some moderation in growth prospects from the recent robust performance.


The European economy has been doing well and likely outperformed the US in growth terms in 2016. The consensus has been too pessimistic on growth in the region which has continued to perform at a relatively consistent and robust pace.

Recently, as measured by data surprises relative to consensus, Europe is the strongest major region in the world. Notwithstanding political risks, Europe should be better supported in 2017. This year, we may see some modest fiscal expansion in Italy and potentially France.

At face value, the fact that Europe is unloved, cheap, and under owned is a function of poor earnings and margin growth there, along with a high-risk premium attributable to political risk.

In the event of a political soft landing, there is scope for much better relative performance but the French presidential elections, scheduled for the second quarter, represent a significant risk for investors.


Proponents for Japan point to the fact that it was the only major developed market to be de-rated in 2016, increasing the value case. Earnings revisions are strong but, despite this, Japanese equity performance remains highly correlated to the yen.

The Bank of Japan has committed to a yield targeting programme which means that, if rates elsewhere are on a rising trend, the yen should decline, boosting corporate earnings. If this occurs, the prospects for Japanese profits and the equity market are good this year.

Accepting 2016 as evidence of a fundamental turn in policy in developed economies at the margin to less globalisation and a world or more protectionism suggests that the fundamental outlook for emerging economies has deteriorated.

The outlook is better today than a year ago, but markets have already factored in much of the improvement. That said, Trump, with pro-cyclical fiscal policy and increased protectionism on global trade has increased the risks of both boom and bust in the years to come.

Paul Niven is manager of Foreign & Colonial investment trust.

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