Before talking seriously about the reflation trade, the field must be cleared of possible geopolitical interference. It's possible?
Yes, it is possible, at least in the short term. The most sensitive crisis point is obviously Korea, but looking at things with detachment we must recognize that we are not yet in a red alert situation. The romantic and ferocious Fidel Castro, as it later became known, was willing, in 1962, to risk the complete destruction of Cuba in order not to give up his missiles aimed at Miami and the Russians had to work hard to reason with him. Kim thinks she's not taking that risk, and she's probably right. The difference is that Kim is holding South Korea hostage, who already has the symptoms of Stockholm syndrome, has elected a pacifist president and has blocked Trump's idea of giving an initial military response in recent weeks. Kim aims for the big victory, which is not simply the survival of his regime, but the detachment of South Korea from the United States.
Beyond the words of fire, the Korean nuclear affair is a chess game that has been going on for twenty years and can still go on for a long time. Kim has been very careful not to violate Japanese territorial space (his missiles have flown over Japan above a hundred kilometers of altitude which is the limit of sovereignty) or the American one. Trump, for his part, has agreed never to violate North Korean territorial space with his fighter jets and has never tried to shoot down Kim's missiles, aware that only two out of three missiles are actually intercepted by his anti-aircraft guns. If Kim's plan is successful, every regime around the world that wants to try to have a long life will try to equip itself with a nuke. This factor of instability will have in the background an even greater one, namely the growing rivalry between America, Russia and China. The good personal relations between Trump, Xi Jinping and Putin are a positive fact, because they allow communication channels to always be kept open, but the large geopolitical areas are objectively and structurally on a commercial, economic and military collision course.
What does this mean for the markets?
Instinctively one thinks of gold, which however is more useful for hedging acute risks than structural ones. For the latter, the answer can only be a significant overweight in defense-related stocks in the broadest sense (aerospace, cybersecurity, electronics, military robotics). There isn't an area of the world, including pacifist Europe, where military spending isn't set to grow in the next few years. US stocks in the sector have had stellar performances over the last year but their multiples, around 20, are still well below those of Faangs and technology in general, while their profits, secured by multi-decade government contracts, are much more sure.
Can the German election significantly dampen the Macron effect on the markets?
2016 was the year it was said that the West was veering towards populism. 2017, for a few months, saw the idea prevail that populism was already over and that the restoration of the Ancien Régime would be fast and aggressive. The reality is more nuanced. Populism will remain endemic and will tend to re-emerge whenever the economic cycle weakens and when migration flows grow again. Specifically, the German elections mean a return to tougher positions in the event of a crisis for large debtors such as Greece and Italy, but not necessarily a repetition of the serious mistakes made in 2011-12. They also signify a greater cacophony in the pro-European chorus. The Commission is thinking of the 27 countries, Macron only of the Eurozone and the Franco-German axis. The FDP thinks of a eurozone that can expel its unruly members, the Greens would also allow aliens to join the euro.
The FDP wants an ESM committed exclusively to monitoring and punishing, Macron would like it instead devoted to borrowing and spending. However, two certainties remain, namely Merkel's central role, all the greater the more the others are divided, and the orientation in any case favorable to some form of greater European integration. The markets gave a rational response to the German vote. The pause in the process of revaluation of the euro, which had already begun before the vote, has become more convinced and profound, but has not turned into a serious correction or a trend reversal. The 1.17-1.20 range can accompany us until December or January, when we will finally have the new government in Berlin. In any case, to see the second part of the euro's rise, we will have to have the Italian elections behind us. The looming pause for the euro of a certain duration rightly gave room to the European stock exchanges. The Dax, paradoxically, is thus the major beneficiary of the German vote.
Is Italy a risk?
Not particularly. Until the vote, we will try to help it by containing the rise in the euro and turning a blind eye and a half to the lack of corrective measures. After the vote, a coalition government, probably with a technical facade, will be inevitable. However, the German vote will induce the markets, in the coming months, to give more weight to the Italian events, which had recently been reclassified from systemic to regional. The recovery of the Italian stock market will continue, but it will have to be accompanied by reassurances on the political front.
Where does the current reflation trade originate from?
There are multiple contributing factors. Inflation in some countries, including the United States and Germany, has been slightly higher than estimated over the past month. Oil is on the rise and its outlook for the next few months looks reasonably solid. Hurricanes are an inflationary supply shock. The Fed has shown that it believes in the strength of the US economy and has decided to confirm the quantitative tightening and the December hike. The American tax reform has come to life and between now and the first months of 2018 will be the absolute protagonist of the political scene. The ongoing reflation trade is an ultralight version of the November-March one and includes, now as then, a more robust dollar, a steeper yield curve (with a rise in long-end yields) and new stock highs with a rotation towards cyclicals and energy. For the moment it does not have much strength, but it has already been able to reverse some expectations, such as those prevailing until two-three weeks ago, of an increasingly weaker dollar and ever lower long-term rates.
Is the reflation trade destined to remain ultralight?
This time the markets will not extend credit and the reflation trade will continue only to the extent that it is supported by concrete progress in tax reform. Senator Corker may have gotten his teeth poisoned with Trump not making him secretary of state, but he's not wrong when he says that the health care reform (failed four times) was a piece of cake compared to what the tax reform will be.
Of two each. Either the reform will be a non-reform and will limit itself to cutting a few rates or, if it wants to be really effective, it will have to balance deeper cuts with fewer deductions and deductions. In the first case the effect will be positive but not radical (a trillion spread over ten years in an economy eight times the Italian one corresponds to an expansive maneuver in Italy of 10-12 billion a year).
In the second we will see an outcry of the affected interests. With Democrats intent on voting against any proposal and a fragile Republican majority, lobbies will only need to convince or buy a senator or two to scupper the most innovative and useful parts of the reform. In any case, any reform will be better than none and since some form of stimulus will most likely eventually emerge, the ongoing reflation trade, provided it keeps its feet on the ground, has its legitimacy. Those who want to sell will have to be patient a little more.
