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The reflation trade has dominated the financial markets over the past months. Has it been a temporary blip, or is there more to come?
Stock markets have rallied and bonds have weakened, while the world economy has gathered strength. This raises the fundamental question of whether we have finally managed to reach enough velocity to break away from the doom-and-gloom scenario called secular stagnation.
Lukas Daalder, Chief Investment Officer of Robeco Investment Solutions, says it boils down to a simple reworking of Shakespeare’s famous phrase: To reflate, or to stagnate – that is the question. “As the economic data that have been published in recent months continues to be firm, the number of articles questioning the validity of the secular stagnation thesis has clearly been on the rise, so it is pretty easy to understand why the theme is deemed important,” he says.
“If secular stagnation is for real, the current economic rebound is certain to be only a temporary thing; a mere blip to be forgotten before the year is through. In that case, the reflation trade that has been with us for the past six months is about to expire, with a rebound in bonds and a decline in stocks the logical call to make.”
“If on the other hand, secular stagnation was little more than yesterday’s fad – a misconception based on an unfortunate string of cyclical headwinds rather than a structural phenomenon – then markets are likely to be treated to more positive surprises in the months or years ahead. Reflation will continue, which means that bonds are still a no-go area, while risky assets will continue to outperform.”
The broadly agreed concept of secular stagnation – as opposed to a normal recession – is that the normal relationship between saving and investment goes haywire. This is partly because crisis-hit banks do not lend out savers’ money to businesses wanting to invest it. The result is chronic economic weakness, low inflation, low interest rates and the constant threat of recession.
What is less agreed upon is how it begins. Potential causes of secular stagnation range from stalling technological progress to the effect of ageing and inequality, in which people approaching retirement and richer citizens save disproportionately more than younger or poorer people. Meanwhile, a damaged financial system following the global financial crisis has led to lower lending by more cautious banks, and both globalization and automation may have distorted developed world investment levels.
And though the use of monetary policy is widely seen as being part of the solution, as central banks have cut interest rates to record lows and launched massive quantitative easing programs, it could also be part of the problem, Daalder says. “Given that we have excess saving in the very high demand for AAA-rated government bonds, it is somewhat counter-intuitive to find that central banks have embarked on big bond-buying programs through QE, thereby increasing the shortage of safe assets,” he says.
“These low yields may in fact be acting as a negative feedback loop, where a shortfall in pension savings leads to more saving, meaning that this policy may have had an adverse effect. With the US Federal Reserve raising rates and the ECB leaning towards tapering, this factor should become less important in the years ahead.”
Daalder says that the whole idea of secular stagnation is therefore a multi-layered problem, which is further amplified by the high level of globalization and interconnectivity of modern financial markets. “It is easy to dismiss it by stating that there has been no growth slowdown on a global level, indicating that it must be a redistribution problem which is bound to dissipate with the passing of time,” he says.
“This is also what history would suggest: secular stagnations have been proclaimed more often in the past, but have never turned out to be as secular as people feared. That’s the easy way out though. Some of the trends have indeed been pretty structural, such as the role of ageing, the declining prices of investment goods, inequality and excess saving in emerging markets, all of which are not expected to radically change in the short run.”
“Which brings us back to the original question: to reflate or to stagnate? The answer isn’t black and white. Labor markets, investment spending and – potentially – government policy led by whatever Trump ends up doing are the key indicators that we will continue to watch on the upside. But the lack of inflation and weak wage growth are clear signs that we haven’t escaped the low yield environment just yet.”