Reflation rally still has legs

Global markets have behaved as many, including Standard Chartered, anticipated: Equities, riskier corporate bonds and industrial commodities rose, while government bonds fell, as business and consumer confidence indicators and corporate earnings improved after years of lacklustre growth and inflation.
The Trump administration’s recent challenges with implementing executive orders and escalation in political uncertainty after the firing of the director of the Federal Bureau of Investigation caused the first speed bump in this reflation rally. Some investors have started to question Trump’s ability to make progress on the critical aspects of the reflation story – implementation of corporate and personal tax cuts, business deregulation and increased infrastructure spending. 
Given this, is it time for investors to hit the pause button? Or is there more to the reflation story?
We at Standard Chartered believe that a US tax deal will be reached, but that this will take time, especially since the Republicans will be keen to ensure that there are, optically at least, revenue-boosting elements to any stimulus package that make any tax cuts budget-neutral over the longer run. 
Therefore, while we are in the late stages of the US business cycle, we still believe the “reflation rally” can run for a while longer. 

Europe, Asia reflating

As it turns out, the reflation theme seems to be broadening beyond US shores, with estimates of economic and corporate-earnings growth generally being revised higher, especially in Europe and Asia. 
We are also seeing signs of a revival in Asian imports and exports, while Russia and Brazil are emerging from a couple of years of recession. China’s policy-induced stability has clearly helped in this regard. 
This bodes well for the medium-term (six-to-12-month) outlook for equity markets. Thus global equities remain Standard Chartered’s preferred asset class. 
Earnings growth expectations are robust and the pivot from economic “muddle-through” to “reflation” suggests this is unlikely to change dramatically. However, a gradual shift away from extremely loose monetary-policy settings and, in some regions, elevated valuations suggest future equity-market gains will be driven by earnings growth as opposed to price-to-earnings multiple-expansion, which is a normal feature at this stage of a cycle. Moreover, monetary policy remains supportive and momentum remains strong. 
The euro area is StanChart’s preferred equity market. Valuations are relatively low compared with the US, while 2017 earnings-growth expectations have risen against the backdrop of an improving domestic economic outlook and reduced fears of a trade war. 
Signs of a pick-up in German consumption and rising exports across the euro area thanks to prior euro weakness imply that the equity market could benefit from a virtuous circle of recovering domestic and external drivers.
StanChart is also more constructive on the outlook for Asia ex-Japan equities. Economic data are improving, and the US dollar’s stability should be a positive, as it means domestic policy settings can remain loose and the region could benefit from a pick-up in foreign portfolio inflows. 
Valuations are reasonable, earnings are expanding at a double-digit pace and the Asia ex-Japan region remains under-owned by institutional investors. Within Asia, India and China (especially the “new economy” sectors) remain StanChart’s preferred markets. 
South Korea may also benefit from reduced domestic political uncertainty, its significant investment in innovation and brand building and from the broader pick-up in world trade growth.

Near-term risks 

Of course, there are always risks of short-term weakness in equities and other riskier assets, especially at this time of the year, given seasonal tendencies, and the geopolitical uncertainties, especially in North Asia. 
Also, some market indicators, such as implied volatility across different asset classes, do hint at investor complacency. However, fund-manager surveys show there is still significant cash sitting on the sidelines that has yet to be deployed into markets. This is usually an indication of further equity market upside. 
More anecdotally, we at Standard Chartered see a similar phenomenon when it comes to client behaviour, with most still focused on income-generating assets rather than pure growth-oriented assets. This implies that any pullback on pro-growth assets is likely to be relatively limited and an opportunity to add exposure.

STEVE BRICE is chief investment strategist at Standard Chartered Bank.