LEADERSHIP SERIES APRIL 2017 A feature article from our U.S. partners Peak Reflation May Be Looming The reflation trade appears intact, but U.S. stock gains could slow if the economy reaches a momentum peak. Jurrien Timmer l Director of Global Macro l @TimmerFidelity Key Takeaways The Fed s dovish hike averted a mini taper tantrum and gave new life to the reflation trade investor optimism that Trump s policies will eventually prove effective in lifting U.S. inflation and growth. Nevertheless, the U.S. economy may be approaching a momentum peak, which could also mean a reflation peak, and lead to a slowdown of the U.S. equity rally. A cyclical (economic) momentum peak generally signals an end to the above-average-return phase of a stock rally; stocks often continue to advance following the peak, but at a more muted pace. Coupled with a weaker U.S. dollar and lower Treasury yields following the dovish Fed hike, a potential reflation peak implies a continued convergence among global equities. In recent weeks, a new mini taper tantrum appeared to be under way yields rose, driven by a sudden jump in the number of Federal Reserve (Fed) rate hikes priced into the markets over the next two years. But the Fed s dovish hike reversed that scenario. What prompted the mini taper tantrum? The Fed, of course. With New York Fed President William Dudley s successful trial balloon of a March hike a few weeks ago, the number of expected hikes priced into the market over the next 24 months jumped from 3.6 to 5.0, and the March hike was 100% priced in. 1 A dovish surprise Although the Fed indeed hiked its baseline rate by 25 basis points at its March 15 16 meeting, it surprised the markets with a so-called dovish hike meaning that it left the dots as is. The dot plot represents the Fed s forward guidance by showing individual policymakers forecasts for the fed funds rate over the next several years. Prior to the March meeting, the consensus was that the Fed would raise its dots to suggest three or four hikes in 2017. But that didn t happen.
And just like that, real yields fell again, as did the U.S. dollar and the number of hikes priced in according to the fed funds forward curve. Contrary to the markets fears, the median dots for 2017 and 2018 stayed right where they were in December. So, as quickly as Dudley s earlier comments caused an upward re-rating of the Fed s tightening path, we are back down to the status quo of two or three hikes in 2017. With its dovish March hike, it appears the Fed simply took advantage of the opportunity to get a hike in now while the markets animal spirits 2 would allow it. With that out of the way, the 10-year Treasury yield came back down following a retest of its December 2016 high of 2.64%. 3 More importantly, the broad U.S. dollar is trending lower again, falling from $102 to $99 over a three-week span in March, according to the U.S. Dollar Index. Also helping the dollar move lower was a euro-favorable outcome to the Dutch election. The French election is still to come, but this was a step in the right direction, eliminating a potential source of risk for the European economy. Emerging-markets equities have now fully recovered from their brief correction, and the Commodity Research Bureau s Raw Industrials Index (a good proxy for global growth) is again reaching new cycle highs. The latter has supported my thesis that we have been in a synchronized global upturn for the past year. The index never wavered during the corrective market action of the past few weeks, holding on to its gains while other commodities corrected lower. More on the global convergence theme, later. Cyclical momentum and U.S. stocks The reflation trade in the U.S. appears to have regained its footing, meaning investors seem to have renewed optimism that Trump s policies will be able to lift U.S. inflation and growth. And with the Fed out of the way for now, we can resume monitoring economic data to get a sense of when the market may reach some sort of reflation peak. A key piece to that puzzle will be to gauge the momentum of high-frequency economic indicators, such as purchasing managers indexes (PMIs). When they reach peak momentum, it will suggest peak reflation, begging the question: What could this mean for U.S. stocks? I ran a simple analysis to see what tended to happen to the stock market when PMIs (indicators of economic growth) reached their initial peak (Exhibit 1). The Institute for Supply Management (ISM) PMI diffusion index reaches an expansionary peak (usually around 60) after recovering from levels indicating economic contraction (below 50). My goal is not to pinpoint a turn in the overall cycle, but to understand what happened to stocks when the economy reached peak momentum. Importantly, a momentum peak for the economy doesn t always indicate a peak in the economic cycle. Far from it. Remember, momentum measures the rate of change, not the direction (growth or contraction). In some cases, the momentum peak was indeed the absolute peak for that cycle (e.g., 1961, 1972, 1987, and 1999). But in many other cases, the economy continued to grow long after the momentum peak, just at a generally slower pace. As shown in the chart, there have been a broad range of cyclical outcomes following momentum peaks. I found that when the ISM index is rising toward a reflation peak, the stock market has tended to post above-average gains. Then when the peak occurs, the market often corrects for a few months, but it s usually not the start of a bear market. Of course, there are exceptions: notably, the 1987 crash, the bear market in 1973 74, and the postbubble decline in 2000 02. But more often than not, the market tends to lose momentum for a short time before rising again. 2
PEAK REFLATION MAY BE LOOMING In other words, a reflation peak generally does not mean a peak in the stock market. But it does mean a loss of momentum. Importantly, Exhibit 1 shows that the market has historically risen faster than its long-term trend-line of 10% per year heading into a momentum peak, but more slowly following the peak. (To the left of the peak, the mean is converging toward the trend-line, while after the peak the mean is diverging from it.) When PMIs and other such economic indicators are still gaining momentum (as they have been since bottoming a year ago), a rising stock market is a likely scenario. But once the ISM index reaches its peak (high 50s or better), more actively inclined investors may want to monitor the level of risk in their portfolios more carefully. The ISM index is currently at 57, suggesting the U.S. economy may be nearing a momentum peak (if we aren t EXHIBIT 1: A cyclical momentum peak doesn t signal a decline for stocks or economic expansion, it implies a slower pace of growth. S&P 500 % Change at Cyclical Momentum Peaks 35% 30% 25% S&P 500: Average S&P 500: Long-Term Trend S&P 500: 2017 20% 15% 10% 5% 0% 5% 10% 15% 20% 25% Cyclical Momentum Peak (Index at +/- 60) PMI Diffusion Index: 2017 PMI Diffusion Index: Average + Standard Deviation Standard Deviation Index 65 60 30% 55 50 45 40 24 18 12 6 0 Months 6 12 18 24 Past performance is no guarantee of future results. This chart is for illustrative purposes only and does not represent actual or future performance of any investment option or strategy. PMIs (purchasing managers indexes) are high-frequency economic indicators tracked by ISM. Cyclical momentum peak: peak of U.S. economic momentum. Standard deviation measures the range of outcomes following ISM momentum peaks. S&P 500 and ISM data from Jan. 1953 through Feb. 2017. Average: the average of all the cycles observed since 1953. Long-term trend: the average compound gain for the S&P 500 since its inception (1928). 2017 S&P 500 data series extends past the vertical axis due to timing of data releases. Source: Haver Analytics, Institute for Supply Management, FactSet, Fidelity Investments, as of Mar. 23, 2017. 30 35 3
already there). The track of the ISM index since a year ago matches the historical average track pretty closely. This suggests that the U.S. stock market may be in the final innings of its above-trend rally phase, and that moving forward, the market will likely advance, but with less momentum. Global implications This takes us back to the theme of global convergence. With the Fed on a steady path that is fully priced in for now, and with the European Central Bank beginning to guide us toward a less accommodative path ahead, the U.S. dollar should be moving lower rather than higher. This is especially true if investors perceive that the Trump fiscal agenda may be losing momentum. If the tax reform with border-adjustment tax agenda fails to happen this year, or if it is replaced with tax relief without spending handcuffs (think Bush-era tax cuts), then the Trump trade could quickly go from a strong-dollar story to a weak-dollar story, leaving the consensus once again wrong-footed. Since the 2009 stock-market bottom, international and emerging-market equities have lagged the S&P 500 by 150 percentage points. Since 2011, these markets have gone nowhere while U.S. stocks have posted significant gains. Now, though, non-u.s. earnings are inflecting higher but from deeper bottoms and against much cheaper multiples. This spells mean-reversion, if you ask me, and could signal opportunities for investors in equity markets abroad. Author Jurrien Timmer l Director of Global Macro, Fidelity Global Asset Allocation Division Jurrien Timmer is the director of Global Macro for the Global Asset Allocation Division of Fidelity Investments, specializing in global macro strategy and tactical asset allocation. He joined Fidelity in 1995 as a technical research analyst. Fidelity Thought Leadership Director Christie Myers provided editorial direction for this article. 4
PEAK REFLATION MAY BE LOOMING For Canadian investors For Canadian prospects and/or Canadian institutional investors only. Offered in each province of Canada by Fidelity Investments Canada ULC in accordance with applicable securities laws. Endnotes 1 Federal Reserve Board, Bloomberg Finance L.P., as of Mar. 1, 2017. 2 A term used to describe human emotion that drives business and consumer confidence. 3 Bloomberg Finance L.P. Unless otherwise disclosed to you, in providing this information, Fidelity is not undertaking to provide impartial investment advice, or to give advice in a fiduciary capacity, in connection with any investment or transaction described herein. Fiduciaries are solely responsible for exercising independent judgment in evaluating any transaction(s) and are assumed to be capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies. Fidelity has a financial interest in any transaction(s) that fiduciaries, and if applicable, their clients, may enter into involving Fidelity s products or services. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Nothing in this content should be considered to be legal or tax advice and you are encouraged to consult your own lawyer, accountant, or other advisor before making any financial decision. Stock markets, especially non-u.s. markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. Investing involves risk, including risk of loss. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. All indices are unmanaged. You cannot invest directly in an index. Index definitions Commodity Research Bureau (CRB) Raw Industrials Index is a sub-index of 13 markets including: burlap, copper scrap, cotton, hides, lead scrap, print cloth, rosin, rubber, steel scrap, tallow, tin, wool tops, and zinc. A Purchasing Managers Index (PMI) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared to the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. The Institute for Supply Management reports the U.S. manufacturing PMI. Standard & Poor s 500 (S&P 500 ) Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500 is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates. Third-party marks are the property of their respective owners; all other marks are the property of Fidelity Investments Canada ULC. If receiving this piece through your relationship with Fidelity Institutional Asset Management (FIAM), this publication may be provided by Fidelity Investments Institutional Services Company, Inc., Fidelity Institutional Asset Management Trust Company, or FIAM LLC, depending on your relationship. If receiving this piece through your relationship with Fidelity Personal & Workplace Investing (PWI) or Fidelity Family Office Services (FFOS), this publication is provided through Fidelity Brokerage Services LLC, Member NYSE, SIPC. If receiving this piece through your relationship with Fidelity Clearing and Custody Solutions or Fidelity Capital Markets, this publication is for institutional investor or investment professional use only. Clearing, custody or other brokerage services are provided through National Financial Services LLC or Fidelity Brokerage Services LLC, Member NYSE, SIPC. 5
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