Is the "reflation bias" getting less biased?

The term “reflation bias” or “reflation trade” has been thrown around for more than a year, describing whatever appears to be the latest and best attempt at synchronized global growth. Since early 2016 this bias has pressed forward on a global basis. To me, there are really two questions to be answered about this seemingly miraculous economic recovery: Is it real, and is it sustainable?

In this context, I think “real” is a bit misleading and the more appropriate term might be “organic” growth, compared to growth modified by central banking and stimulus. In late 2015, it felt like the global economy was on the ropes. Industrial production was falling globally, trade was soft, Purchasing Managers’ Index (PMI) composites continued to disappoint as they drifted toward the expansion-contraction barrier of 50 (and dropped below 50 in emerging markets), and commodities were experiencing a dramatic decline (for example, oil prices were falling sharply until their low of below $30 a barrel in February 2016).

US Federal Reserve Chair Janet Yellen and the Fed — in a somewhat quizzical or cavalier move, depending on which side of the outlook you sat on — raised rates in this rather fragile-looking environment and promised four more hikes in 2016. Fast forward into early 2016 and markets gave a not-so-gentle pushback on the Fed’s move and its intentions to hike rates further. Oil continued falling fast, China’s economy was sputtering at sub-50 in PMI, the dollar was rallying hard, and risk markets were once again at the precipice.

Economics were already starting to bottom out on a cyclical basis and starting to turn upward when three things happened in early 2016 in reaction to markets and the perceived overall softness in the data:

  • Janet Yellen and the Fed panicked on US dollar strength and Chinese yuan weakness.
  • China added a ton of liquidity to its system and further bolstered its housing market.
  • The Organization of the Petroleum Exporting Countries (OPEC) managed to coerce oil prices higher through some initial sleight of hand that turned into modest supply cuts later.

Since the second quarter of 2016, I have argued that the reflation bias we are witnessing is simply the result of a cyclical and synchronized global economic mean reversion off the lows and a very aggressive policy response to that same downward synchronization in the global economy. In other words, we are not only being fooled by randomness as we witness a cyclical mean reversion from the late 2015–early 2016 economic lows to the current highs, this already synchronized mean reversion was further bolstered by interventions across multiple markets in a reaction to the market panic of early 2016 during those same cyclical lows.

The policy reactions helped stabilize markets and boost economics when cyclical factors were already set for a cyclical and synchronized upswing. This nitro boost for the global economy has been looked at by markets and economists as the latest and best chance to achieve a self-sustaining and organic recovery. Many have turned away from common sense, adopting a view that the structural factors that pressured global growth had somehow magically dissipated in this recent bout of economic hope.

Markets have added more fuel to the reflationary bias through the “Trump trade” — the simultaneous surge in US stocks, Treasury yields, and the US dollar that followed Donald Trump’s presidential victory — which seems to describe similar misplaced hopes. Ultimately, none of the structural factors that have weighed on growth have gone away. Technology, demographics, debt/delevering, and the further globalization and mobility of labor will ultimately weigh on jobs and wages, despite this seeming reflationary bias — which, as we’ve pointed out above, looks more like a combination of mean reversion in combination with inorganic stimulus-driven nonsustainable growth. In this way, I believe the reflation bias can be expected to become less biased, as the stimulus from 2016 starts to run out of steam. We have lost a lot of momentum in global data recently. It could be the first sign that it’s time to fade the reflation hope trade.

The views expressed represent the author’s assessment of the market environment as of May 2017 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

The Purchasing Managers’ Index is an indicator of the economic health of the manufacturing sector.

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