JP Morgan is one of the few banks that has done a superb job in connecting the dots of the Fed’s liquidity induced operations leading to reflation and then ultimately leading to recovery. In their latest strategy notes they remain very bullish (as they were well before the rally began) and fear neither inflation nor deflation:
“Many fundamental investors are uncomfortable with a rally driven by cheap money. We understand this unease, but still want to ride this rally, as it is stimulative policies that are required to get the economy going. We would prefer higher asset prices driven by a stronger economy, but accept that we will likely get the reverse –– a stronger economy driven by higher asset prices.
More important news was confirmation of our economists’ long-standing forecast that core inflation in developed economies will fall below 1% this year and next. Euro area core inflation has fallen to a record low of 0.8% oya, and the US fell to the same rate over the past six month (only 1.3% over the past 12 months. Japan’s rate has fallen to a record low. Disinflation is good for risky markets to the extent that it keeps central banks near zero policy rates and depresses corporate costs, thus pushing up profit margins. But inflation falling below 1% is bad for risky assets to the extent it brings us to the verge of Japanese-style deflation.
Our view is that disinflation will not turn into deflation, neither in North America nor in Europe, although the Euro Area is probably more at risk. Central banks will continue to threaten to use the printing press more aggressively if deflationary expectations were to emerge. In addition, Japan’s deflation was ultimately brought on by two-decades of corporate delevering to undo the damage on their balance sheets from collapses in equity and real estate prices. European and US companies, in contrast, hold much less of these assets and are in much better health. They have started to expand again through capex, and now likely also through hiring and inventories.”
How to play it? Remain in the risk trade as inflation remains low. Equities should continue to perform well on the back of stronger than expected profits. Inflows are also starting to support higher asset prices.
- Fixed Income –– Stay short duration in the UK, but long in local EM debt.
- Equities –– Solid economic activity data, rising earnings forecasts and stronger inflows into funds point to a continuation of the rally.
- Credit –– Overweight high-spread versus low-spread sectors.
- FX –– CAD and CHF are our favourite longs.
- Commodities –– Strong manufacturing growth and restocking should support base metal prices in H1.