The Reflation Trade Reverses


Judging by the recent slump in reflation plays — assets expected to benefit from stronger growth and higher inflation — nearly all the "Trump bump" that followed the election has been reversed.

• Small-company and other stocks with mostly domestic operations — expected to benefit from tax reform and a stronger U.S. economy — have given back almost all of their relative performance advantage since Election Day.

• U.S. bond yields have dropped sharply since mid-March, with yields on 10-year Treasury bonds falling to 2.2%, the lowest level since Nov. 10.Ā 

• The drop in bond yields has crimped banking stocks. Higher bond yields would help banks' profit margins.

Also helpful would be additional increases in the overnight cost of money, but Wall Street is increasingly skeptical about the Federal Reserve's plan for two more rate hikes this year.

Two trends — softer-than-expected economic data and slower-than-expected legislative progress in Washington — have driven these reversals. While surveys show U.S. consumer confidence near all-time highs, consumer spending has been disappointing, with two straight months of lower retail sales. The Atlanta Fed now expects annualized U.S. economic growth of 0.5% for the March quarter, down from the 3% expected in early February.

Meanwhile, President Trump and the Republican Congress have made little headway implementing the pro-growth initiatives that were expected to give the economy a lift. Republicans seem divided on the best path for tax reform, and Democrats appear unwilling to help Trump achieve any legislative victories.

Handicapping events in Washington is tough, but Republicans will be under pressure to deliver on tax reform prior to the 2018 midterm elections. Either way, attaching too much importance to any legislation is usually a mistake. The economy's prospects are more important, and there are reasons for optimism regardless of what Congress does.

Forecasters expect U.S. growth to accelerate in the remainder of 2017, keeping with the seasonal pattern of recent years. Also, expectations for overseas economies have improved, with the International Monetary Fund recently lifting its 2017 forecast for global growth to 3.5%, which would be a five-year high.

Even if U.S. annualized growth remains stuck near 2% and overseas growth improves only modestly, U.S. companies could continue to report decent profit growth over the next year.


The market's reaction to earnings reports should be watched closely. The Dow Transports, closely tied to the outlook for U.S. and global growth, deserve particular attention. For now, our buy lists have more than 94% in stocks.

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