Central bankers have returned to the limelight with a vengeance in the past few days and just as the quarter ends, markets are shifting their perceptions about the speed of monetary policy changes.  The previous title of this piece when I sat down to write it at the beginning this week, “Has anyone seen the reflation trade?”, has become rather irrelevant for now.

Half-time report

This year, equity market leadership has had a distinctly cautious feel; bond markets have been pretty chipper, the dollar has declined and commodities have been poor.  Looking back, the “Trump Bump” was a relatively transitory phase.  In fact, the reflation and value renaissance of 2016 has been fading as we returned to the ancien régime of growth and mid-cap stocks leading the charge.

At the headline level, equity markets have been nigh-on heroic given the challenges that lie before them, but to participate fully, you needed to select the right sectors.  Happy days if you were biased towards the steadier sectors of personal goods, healthcare and tobacco, in addition to technology of course; it’s not been so much fun if you have been exposed to energy, mining and retail.

These trends are plain to see in the performance league tables when we observe the year to date.  Looking at the IA UK All Companies sector, we see dyed-in-the-wool value managers languishing at the bottom, while mid-cap funds bask in top-of-table glory.  2015 redux!

In fixed income land, government bonds have once again confounded many investors who believed that yields were poised to move materially higher as economic growth took hold.  Before the very recent rout, 10-year gilt yields fell back from around 1.4% towards 1.0%; US government yields retreated from the technically-significant 2.6% level in March and headed towards 2.1%.  Returns from corporate bonds have been robust and supported by a relatively benign backdrop for credit and, as significant, strong investor demand for the asset class.

So, the first half of the year is likely to have been tough for reflationistas, who would logically have favoured an underweight in fixed income, coupled with an underweight in bond proxies.  Exposure to commodities would have dented their chances further, with the oil price falling away, copper going nowhere and iron ore collapsing in the past few weeks.  Gold has been a happier tale, although arguably, its robust performance so far this year has had less to do with expected inflation and more to do with risk aversion.

The central bankers are back!

But stop! Right on cue, just before the end of the quarter, the mighty central bankers have returned to shake investors’ assumptions.  Perhaps they noticed that, according to Bloomberg, currency volatility has hit a 20-year low, US treasuries are locked into their narrowest trading range since the 1970s and the VIX gauge of equity volatility is at its lowest for two decades…

With various utterances forthcoming from monetary officials in the past few days, markets have woken up to the idea that, all at once, four out of the five main central banks are talking about the need to tighten financial conditions.  Zut alors, Mr Draghi even mentioned the “reflation” word, which sent German bunds into a tailspin, prompting the ECB to re-state their comments.  Meanwhile, Mrs Yellen has not altered her plans for continued monetary policy tightening, with an objective to start shrinking its $4.5 trillion balance sheet later this year.  (Interestingly, she also saw fit to comment that that, ”asset valuations, by some measures, look high”.)  Mark Carney also wrong-footed the market by stepping over into the hawkish camp, commenting that interest rate rises will be necessary if investment growth and wage increases put upward pressure on inflation.  Finally, the Bank of Canada’s governor has said that interest rate cuts appear to have done their job and that rates are likely to rise imminently.  With Japanese inflation persistently subdued, Mr Kuroda of the Bank of Japan has not been able to join this party yet; the 2% target is still a long way off.

Flip flop

This onslaught of commentary has sent a shock-wave through currency and fixed income markets, reminding us that investors remain hyper-sensitive to changes in the monetary regime. Bond yields have moved up smartly and the euro and the pound have strengthened against the US dollar.  In equity markets, banking stocks, which had been under pressure, have been boosted by the prospect of a more favourable interest rate structure, while the most expensive technology stocks find themselves in the line of fire.

Capitalising upon these kinds of short-term market moves is fiendishly difficult, and, in reality, few managers attempt to; fewer still do it successfully over time.  Managers who take well-considered, strategic views can easily be kicked to the bottom of the performance tables, particularly when markets behave in a binary fashion.  We should be prepared for more shifting sands this summer as central bankers prepare to withdraw their largesse.  Flip flops may not be restricted to the beaches.