‘Reflation’ theme extends and broadens – Goldman Sachs

Analysts at Goldman Sachs think there is scope for the ‘reflation’ trade to perform better in 2017 for a combination of factors.

Key Quotes

“First, thanks to base effects from energy components, headline CPI inflation will rise entering 2017 across the major advanced economies, and this could influence inflation expectations positively.”

“Second, with ‘austerity’ now in the rear-view mirror, the onus of stimulating demand appears to be shifting from central banks towards the fiscal authorities. We forecast a relatively large, synchronised support to GDP growth from the public sector in Japan, China, the US and Europe. Only part of this will go to expand potential output, with the bulk potentially stoking inflationary pressures.”

“Third, the major central banks have been aiming for inflation to run at/above their 2% target for some time to compensate for the undershooting in recent years. With this objective, the ECB, BoE and BoJ are all creating more ‘fiscal headroom’ for their respective Treasuries through large-scale purchases of government bonds. We expect these purchases to continue throughout 2017. In this context, we think that greater attention will be given by both the BoJ and the ECB to prevent an excessive flattening of their respective nominal term structures of rates. This should allow the inflation forwards to expand.”

“With these considerations in mind, our Top Trade for 2017 consists in being long both US$ and EUR 10-year inflation. We like the US leg of the trade because expansionary fiscal policies in an economy already operating close to full capacity will likely push up domestic price and wage inflation. Along with our dovish views on the ECB, there are two more reasons why we like the EUR leg of this trade: (i) the potential for EUR to depreciate in line with the views of our FX strategists should push up the inflation risk premium in EUR inflation swaps and (ii) we are starting from a very pessimistic skew in inflation expectations in the Euro area, underscored by the inflation options market assigning a 70% chance of CPI staying below 1% over the next 5-years.”

“There is clear systemic risk to the trade relating to the evolution of the general economic outlook. Unlike in 2016, we think that the downside risks from commodity prices are lower thanks to base effects and better valuations in the complex.”