The resurgence of reflation risk

The first six months of the year have been characterised by an unwinding of the reflation trade, strong performance from risk assets and low volatility. Sharpe ratios are remarkably high – but we don’t think this is sustainable.

Inflation expectations have declined since the Federal Reserve raised short-term interest rates in March this year.
Both nominal and break-even inflation rates lost ground in the aftermath of the meeting. The surge in inflation expectations last summer had already been tamed by December’s interest-rate rise, and it is clear that the Federal Reserve is no longer behind the curve.
Another factor in declining inflation expectations has been a 25% drop in oil prices since the end of February. Commodity markets remain under pressure, with supply generally higher than demand at the present time.

Against this backdrop, risk assets have performed remarkably well, led by growth assets. Developed equity markets have gained more than 10%, with emerging equities delivering stronger returns again. Emerging local currency debt has also been a good performer, while credit spreads have tightened across the board. In this environment, carry strategies have delivered returns not seen since the financial crisis.
The strong performance from growth assets can be seen in the following chart, which illustrates the relative performance of our growth, recession, inflation and market stress baskets since the end of last year.

The third feature of markets so far this year has been remarkably low levels of volatility. The pricing of risk has rarely been as low as it is today.
This trend can be explained by several factors. Some are cyclical, such as low volatility in macroeconomic data due to the accommodative monetary policy and stable and synchronised global growth. Others are more structural, such as the market structure of the volatility market, where the expensive cost of hedging has tempted investors to sell volatility to receive the carry from the VIX curve.

Taken together, risk assets have generated remarkably high Sharpe ratios this year of 3.1 for the MSCI World and 3.5 for the MSCI Emerging Markets Index on an annualised basis. Attractive as these appear to be, our assessment is that these are not sustainable from here.

Team Cross Asset Solutions – Unigestion