Labels Matter: What to Call the Stock Rally
Although they are far from perfect, labels play an important role in providing shorthand signals for bigger phenomena. This, in turn, influences how people think about the past, present and future, and which actions would be warranted and why.
I would argue that the impressive ongoing stock market rally is such a case and that the various labels being attributed to it have different implications about its dynamics and determining factors, and how investors should think about positioning their exposure.
Some continue to call the latest phase of the impressive run in stocks the “Trump Trade.” Its fuel comes from what is deemed as an unusually pro-business administration and its promises to implement measures that would directly benefit companies’ bottom line (such as tax cuts, deregulation and cheaper repatriation of cash held abroad). The beneficial impact on investment sentiment is reinforced by the administration’s stated intention to reform the tax code in a pro-growth fashion and to implement an infrastructure program.
In its early phases (November-December 2016), the Trump Trade featured a surge in stocks powered by financials and industrials, two sectors that were seen to benefit most in both absolute and relative terms. The dollar strengthened and U.S. government bond yields rose, not just in absolute terms but also relative to German bunds, with the differential for 10-year maturities widening to about 220 basis points.
In the months that have followed, these characteristics of the Trump Trade have been reversed. The leadership of the stock markets has rotated, the dollar has weakened, and the U.S.-German differential is back down to around 190 basis points.
For these reasons, some prefer to use “Reflation Trade” to describe the current stock market rally. Under this label, the equity surge is being powered by brighter prospects for the global economy due to a synchronized pickup in the advanced world -- particularly, expanding economic activity in Europe and the U.S. -- and stabilization in the major emerging economies of Brazil, China and Russia.
The postulated hand-off from the initial Trump Trade (mainly a November-December phenomenon) to the Reflation Trade would help explain how new record levels for the major U.S. stock indices have been accompanied by lower interest rate differentials and a weaker dollar.
The third label, “Liquidity Trade,” places less emphasis on the economic and policy considerations of the other two, and more on powerful injections (actual and expected) of liquidity into the marketplace -- particularly from central banks, corporate balance sheets and households. The phenomenon is turbocharged by cash that was previously sidelined by the trauma of the global financial crisis and is now being attracted into the marketplace.
These three labels point to different factors to monitor in assessing the prospects for stocks, and they are not mutually exclusive. Specifically:
- If you believe in the Trump Trade, you would focus on the design of pro-growth and pro-corporate policies by the White House and, in collaboration with Congress, implementation.
- If you believe in the Reflation Trade, you would focus on the extent to which the recent surge in household and corporate sentiment on both sides of the Atlantic is being translated into stronger “hard” data. You would also look at how the emerging world is consolidating its economic stabilization.
- If you believe in the Liquidity Trade, you would assess the sustainability of the three sources of liquidity injection, with a particular focus on central bank policies.
The investment implications also differ.
Under the Trump trade, you would load up on U.S. industrials, financials and the dollar, while shorting Treasuries. Under the Reflation Trade, you would take a much more global equity exposure. Under the Liquidity Trade, you would seek to gradually reduce investment dollars at risk, while rotating more of the remaining market exposure to lagging international market segments.
My own feeling is that, with the political implementation outlook having gotten more complicated and likely to remain so, the current rally is essentially a Liquidity Trade amplified by a reflationary flavor. To develop a much more robust underpinning, it would need to be anchored by stronger global reflation and better prospects for pro-growth policies in the U.S. -- the evidence for which is not overwhelming, at least for now.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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Mohamed A. El-Erian at firstname.lastname@example.org
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