The rebound in financial markets reflects strong optimism among market participants that real and nominal economic growth and inflation are about to get stronger in the coming years. This view has supported a sharp rebound in valuation ratios (see chart above). At the same time, USD has continued appreciating against most currencies, and the fixed income market has consolidated on the back of rising yields.
This « reflation trade » is not without risk, mainly because the goods news are mostly priced in.
So where are the risks ? Merrill’s strategist James Barty has listed 3 of them in a report published on Jan 13:
« First, the fixed income sell-off goes into overdrive and that yields overshoot. As we discussed above another 50-75bp would likely put the bond market into such territory. We think we are reasonably well hedged against that with our short real rates and long USD trades. The latter as we suspect that any bond rout would be led by the US.
Second, a trade war triggered by the new administration either naming China as a currency manipulator or bringing in tariffs or potentially both. We think that would be particularly adverse for EM which is why we added our USD/CNH call in our last publication. We also think it would likely be inflationary so it would likely be adverse for bond markets. It is unclear what it means for the dollar other than vs EM currencies though. It is likely a risk off event for equities.
Third, a growth shock of some kind similar to Q1 of last year. Quite where this comes from is unclear, maybe China if the authorities withdraw stimulus too quickly. In the immediate future we see this as the least likely outcome but it is one that we are particularly aware of since the overall stance of our current trades is vulnerable to a risk off event where equities, the USD and yields all fall at the same time, which is what this would likely result in. »
Despite those risks, Merrill X-asset view remains so far in favor of risky assets (European, Japanese, EM Asia equities, long USD, short US/UK rates, hedges through short EUR inflation swaps and V2X against political risk in Europe).