Reflationary theme:Is it peaking?We think so

Last night the US was yet another economy to have reported higher thanexpected headline inflation. While not unexpected (with the bulk of inflationarypressures coming from the commodities round trip, with neither core CPI, corePPI nor wages exhibiting the same pressures), it does place a question markon how investors would interpret and trade this inflationary theme.

As discussed in our ’17 preview (here), there are three possible outcomes.

First, it is reasonable to assume that unless commodity prices increasefurther, the peak headline inflation would occur in the next several months andunless there is a strong fundamental impulse, inflation rates would startdrifting down and investors could start (again) discussing disinflationarypressures. Second, if monetary policies stayed too low for too long, then anyfurther stimulus could lead to stagflation (inflationary pressures rising fasterthan real GDP). Third, ‘sunny goldilocks’ of healthy reflation rekindling privatesector productivity and as a result, real outcomes outpacing inflation.

Investment strategies in these three outcomes would be distinctly different. Ina healthy reflation, global growth rates and nominal GDP accelerate withoutprompting any erosion in real GDP. Under this outcome, lower tail risks, anopportunity to deleverage would be combined with higher US deficits, allowingUS$/DXY to depreciate. Excellent news for EM equities, particularly marketsthat are geared to global growth and rely on terms of trade (e.g. Indo & Mal). Itwould be great news for equities, and in particular, financials and cyclicals.

This is what investors seem to assume (or goldilocks of accelerating but stillmoderate inflation, aided by monetary support and some fiscal stimulus).

What could go wrong? First, rising inflation is essentially a tax onconsumers, who were the key growth driver (hence real wages are alreadyeroding). Second, there is a risk that Fed might feel that it is falling behind thecurve, and the market might over-tighten financial conditions. Given highleverage, rising cost of capital could be difficult to accommodate. Third,secular disinflationary pressures remain strong, driven by technology, overfinancialization and associated over capacity. Either return to disinflation orappearance of stagflation would derail equity rally. Both outcomes are likely toresult in higher US$/DXY and EM equities would under perform. In bothcases, quality and growth would once again outperform value and cyclicals.

Country-wise, local and liquid would outperform global and illiquid. India, Philand China would do better in this climate. Indo should be the worst market.