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How much reflation should we expect?

By Jim Picerno, Director of Analytics


The Treasury market’s implied inflation forecast has been rebounding since diving in late-March, when the coronavirus pandemic shocked markets around the world. Back in March, the consensus view is that deflation was a possibility, perhaps even likely. But the market is in the process of rethinking that view.


At one point the yield spread on the 5-year nominal Treasury less its inflation-indexed counterpart fell to nearly zero. Since then, the market’s inflation expectations have headed higher. The 5-year’s forecast was well over 1% in recent days.


The leading source for the rebound: extraordinary fiscal and monetary stimulus to battle the economic blowback from the pandemic.


Will the reflation upward trend continue? Much depends on how the economy recovers and whether there’s additional stimulus. In turn, those factors depend (in part) on how soon an effective Covid-19 vaccine is developed and distributed. The best-case scenario, according to Dr. Anthony Fauci, the top infectious disease expert in the US government: late-2020 at the earliest.


Meantime, there’s probably a limit to recent rebound in inflation expectations (and the official measures of inflation). With coronavirus infection rates bouncing back in the U.S., the jury’s still out on how quickly economic growth (and inflation) will recover.

Bonds have become a cash proxy with high risk


There is near universal agreement that the coronavirus threat will continue to lurk until a vaccine arrives. If so, then it’s likely that demand will remain firm for the safe-haven U.S. Treasuries. Rising yields remain a low-probability threat for now, courtesy of the ongoing pandemic and the economic blowback. But with government bonds trading at ultra-low yields, investors should be ever mindful of the risks.


Consider the 5-year note, with a current yield trading below 0.4% recently. The security has effectively become a “high-yield” cash proxy with a potential for high risk if and when interest rates rise. (Bond prices fall when yields rise and vice versa.) The risk-return tradeoff for bonds has almost never looked worse.

Accordingly, investors may want to consider reducing duration risk in their bond holdings. Shortening bond duration is less about forecasting vs. recognizing simple facts, namely: as bond yields fall further from current levels, the advantage of return-enhancement over cash fades while risk continues to rise.


That doesn’t mean long -term Treasuries are a sure-loser for the near term. But for the medium- and long-term, Treasuries are increasingly a market for speculators rather than investors.

How to weight China in global equity portfolios?


China is the world’s second-largest economy after the U.S. and economists project that the Middle Kingdom is on track to overtake America within a decade or two, perhaps sooner. Yet China’s role in global equity strategies tends to punch well below its economic weight.


Many portfolio managers underplay China’s influence in equity portfolios too. Ditto for individual investors, who tend to regard the country as an afterthought. Consider the iShares MCHI All Country World Index ETF (ACWI), which tracks a passive measure of global stock markets. The U.S. weight was nearly 58%, followed by Japan (7.2%) and China (5.0%), as of June 24, according to iShares.


Ranking China on economic terms paints a different picture. Indeed, the Middle Kingdom’s estimated share of global gross domestic product for 2020 is nearly 20%, based on numbers from Statista.com.


Why the disconnect between China’s market weight and economic heft? Part of the answer may be that investors have been slow to recognize the country’s rapid economic rise and still think of it as one of many “emerging markets.” Another factor may be China’s heavy regulatory hand, which limits foreign capital’s access.


Whatever the reason, investors should be aware that China plays a bigger role in global equity allocations than casual observation of portfolio strategies and equity indexes suggest. That’s starting to change, but there’s still a considerable gap.


Minds will differ on whether to overweight, underweight or hold a market-neutral allocation in Chinese stocks, but many investors have an underweight strategy due to oversight rather than conviction. That may or may not turn out to be a savvy decision. But as a general rule, it’s advisable to make country-weight decisions based on informed analysis rather than passive carelessness.

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